As the reinsurance sector’s capitalisation continues to rise and pressure pricing, thanks to well-capitalised traditional balance-sheets along with growing alternative capital, it is likely to contribute to lower returns on equity for reinsurers and fuel the M&A trend, says Fitch.
Fitch Ratings says that the expansion of alternative capital sources is exacerbating the over-capitalisation of the sector, which while lowering returns on equity and sustaining the pressure to merge or acquire, the effects will be particularly felt by Bermudian reinsurers.
The timing is particularly bad, notes Fitch, as interest in accessing the returns of the insurance and reinsurance market among institutional investors has been rising sharply at the same time as the market has faced low levels of catastrophe losses resulting in strong years of earnings.
This has enabled traditional reinsurers to become well-capitalised right at the same time as alternative capital inflows have grown, exacerbating the pressures on reinsurers.
“Combined with low interest rates, the industry’s returns have the potential to trend meaningfully lower over the coming years,” Fitch explains.
In fact, Fitch already says that returns on equity have been falling, with the Bermuda reinsurance market as a whole seeing a combined 11.1% net return on average equity through the first nine months of 2014, down from 12.9% in 2013.
Fitch says that it does see alternative capital sources as beneficial to the reinsurance industry, up to a point, however over-capitalisation and expanding coverage, in an environment of shrinking premiums, are factors that have combined to drive “intense, industry-wide competition,” Fitch says.
Fitch notes that these factors have contributed to its negative outlook for the global reinsurance market, but it feels the Bermudian catastrophe specialist reinsurers are most exposed as they compete directly with insurance-linked securities (ILS) and alternative capital.
Fitch cites examples such as Watford Re, as an evolution of the interest of hedge funds and private equity in more directly accessing the risk through reinsurance vehicles set up like sidecars.
The ratings agency believes “there is a higher potential for more partnering deals where an established reinsurer pairs with an established hedge fund.” And notes “These deals face fewer challenges in establishing track records, launching operations and attracting new customers.”
Fitch says that hedge funds backing reinsurers have added about $4.4 billion of capital to the Bermuda reinsurance market since 2012, which it feels is a significant enough amount to have a “meaningfully incremental impact on pricing in the market.”
Alternative capital has helped to fuel the desire for M&A, Fitch says, as the excess capital in the reinsurance space and soft pricing conditions have helped to outweigh sellers’ concerns about entering into an M&A transaction.
These comments are from Fitch’s latest report on the Bermuda reinsurance market, which essentially boils down to increased capital, both traditional and alternative or third-party from hedge funds and ILS, are pressuring pricing, promoting consolidation and structurally changing the reinsurance space.
The capital markets are a “permanent fixture” of this, says Fitch, and are “here to stay
as a structural change to the reinsurance sector.” But Fitch also notes that Bermuda reinsurers are among the biggest adopters of alternative capital as well and the market is a centre of ILS and alternative capital expertise.
Fitch’s ultimate outlook for reinsurance keeps worsening, as it now says; “The onslaught of alternative capital, which Fitch views as enduring, leads us to expect that prices will continue to fall, and for terms and conditions to weaken in 2015 across a wider range of business lines.”
That will require discipline and sound management, from a risk and expense point of view, as well as a need to be focused on returns, portfolio management and reducing costs-of-capital.
The real question though is how the reinsurance market transitions. From one where return on equity matters most, to a perhaps structurally different one where returns on difference sources of capital deployed are more important, as increasingly the capital comes from more efficient, often lower-cost sources.