Fitch Ratings views the emergence of alternative capital and insurance-linked securities (ILS) and the resulting pressure as negative for traditional reinsurers, while also expecting that the pricing floor in reinsurance may not be reached in 2016.
In an update based on its views following the Monte Carlo Rendez-vous, Fitch says it remains negative on the prospects for the reinsurance industry.
On alternative capital and its growth, Fitch says that on balance it views this as “negative for traditional reinsurers’ credit quality and financial strength in the current competitive market environment.”
Fitch notes that for some companies there are some positives due to alternative capital, but the growing capacity and competition added by ILS players and capital market investors has “served to meaningfully dampen reinsurance pricing and resulted in a deteriorating profitability profile for the reinsurance sector.”
Fitch notes that the debate surrounding alternative reinsurance capital and ILS has moved on from one on its permanence to a discussion on understanding the long-term impact it is going to have on reinsurance and insurance.
“It is now widely accepted that a meaningful proportion of alternative capital is likely to remain, in the aftermath or a major loss event or should interest rates return to higher levels,” Fitch explains, which is encouraging that the conversation has moved on.
The future growth and development of the insurance-linked securities (ILS) market was also debated, Fitch notes, with the growth of non-catastrophe property and casualty lines in ILS expected to be slower than was seen for property catastrophe risks.
That is no surprise and most observers would be in agreement that expansion into non-catastrophe risks will be slow and steady, as opportunities are identified and ways to enter those markets are established.
Fitch also notes that it is “unclear whether the size of losses that would be required to satisfy the return requirements of investors would ever be generated” in non-catastrophe property ILS.”
Fitch also notes the discussion around cyber risks, that there are perhaps certain areas of that emerging exposure where risks could be segregated, understood, modelled and perhaps parametric triggers applied to them, something we discuss in more detail here.
On pricing prospects for the key January 1st 2016 reinsurance renewals Fitch notes that it is “unconvinced that a pricing floor will be reached during 2016.”
Following discussions with reinsurers and cedants in Monte Carlo, Fitch says that despite the market being optimistic that an equilibrium and floor for pricing will be found, “a number of fundamental factors that influence pricing remain negative.”
Fitch says that reinsurance demand will remain “subdued” while strong levels of traditional and alternative reinsurance capital will ensure “fierce supply-side competition.”
Perhaps most concerning for reinsurers and the markets future prospects, Fitch says that it “believes some reinsurers view defending market share by writing business below the technical price floor as being an acceptable risk.”
This is interesting, as all the major reinsurers have expressed an expectation that a pricing floor will be found, and many analysts do not believe reinsurers will continue to compete on price. However, Fitch is perhaps right as reinsurers do need to maintain their underwriting levels and when you look at the growth of premiums coming through from some companies, it is hard to believe that it is all at profitable levels.
If indeed that turns out to be the case, we will see an increasing level of scrutiny on reinsurers from the rating agencies and analysts, as they try to identify who might be writing below technical levels, how it might impact them and their shareholders.
It also raises the prospects of some surprises, when the market begins to see an uptick in losses, as any reinsurers loosening discipline in order to underwrite business could get caught out with an outsized share of the industries losses.
This also brings into question the reinsurers with sidecars and third-party capital vehicles. If business is going to get underwritten at below technical levels, how are decisions made as to where that business sits, on which balance-sheet and could different balance-sheets see different levels of exposure? That will make transparency and openness vital for reinsurers running third-party capital vehicles or sidecars, as investors will not tolerate facing outsized losses, unless of course that was a risk that was communicated as part of the strategy.
Finally, if reinsurers do push prices down further, how will ILS fund managers and alternative capital respond? ILS managers have mandates which seek to guarantee investors a minimum return, they also have strong and personal relationships with their investors, making it much harder to drop underwriting standards (than if you have thousands of shareholders).
If pricing does continue to decline we could see some additional returns of capital by ILS. However, we could also see some cedants becoming nervous about the exposures that large reinsurers are taking on, pushing them to look to different sources of capacity, which may be considered more secure in times of stress (collateralised).
If discipline wanes, the buyers may decided that they can’t risk their protection providers facing outsized losses and becoming unable to pay their claims. That could serve to make collateralised protection from ILS players even more attractive.