As pressure proves unsustainable, reinsurance cycle set to change

Pressure on reinsurance rates is unsustainable over the long-term, despite ceding companies desire to take advantage of soft market conditions A.M. Best believes, but the changes in buying and market dynamics are likely to result in a changed cycle.

A.M. Best explained in a report this week that the reinsurance market has actually benefited from some increased cessions in recent years, as large ceding companies sought to become more strategic in their reinsurance buying, adapt to regulatory change and take advantage of the soft market opportunity.

Cession rates at some of the top insurers in Europe actually leapt up, once the trend of centralisation and consolidation was completed, and while reinsurance buying remains higher than it was a few years ago, A.M. Best said that increases in cessions will now slow down.

As a result retention rate declines will begin to slow, A.M. Best suggests, helping to instill greater stability in the reinsurance market.

“Although primary insurers are trying to take advantage of soft market conditions, in the long-term the pressure on rates is unsustainable,” the rating agency says.

As a result, “reinsurance premiums are likely to move toward a more stable level,” the rating agency forecasts, given the stress placed on reinsurers profits as they barely cover cost of capital.

So more reinsurance price stability expected, which has been forecast for a while, with an expectation that rates may continue to decline but only by very marginal amounts at future renewals.

However, in the past, a situation where reinsurers became so stressed on the profit side that rates bottomed out would typically result in some increasing prices, particularly after the next major catastrophe event came along.

But a number of developments from recent years could mean that just doesn’t happen, to the same degree anymore, as the cycle adjusts to the continuing imposition of a new normal.

While reinsurers are stressed they do have other avenues for profit these days, at least the largest players, looking outside of reinsurance and into primary insurance where they increasingly deploy their capacity in order to recoup better margins by moving closer to the source of the risk. Hannover Re gave a prime example of this yesterday.

At the same time the very large reinsurers are touting their ability to tailor coverage for clients, in ways that smaller reinsurers cannot compete with, leveraging their deep analytical and technical expertise to design products that are hard to replicate without teams of science and risk modeling experts.

This means acquiring premiums may not be an issue for the major reinsurers at the bottom of this cycle, while margins may also hold up much better than in soft markets of the past, as they move to the front of the queue and increasing cut out transactional dead-wood sitting between them and the risk.

Buying habits have also changed during this cycle and the shift to multi-year reinsurance coverage has not yet been fully experienced at renewals. There is going to be a shift in when cover is bought, which could make the relationships held with cedents increasingly vital.

Another factor in multi-year reinsurance is that the years between the renewal are a prime time for major reinsurers to work on making themselves indispensable to cedents, by offering insights, analytics and services that enhance the offering even between the renewal years.

That could result in an increasing proportion of these renewals going to major companies, while smaller reinsurance markets could become a little more irrelevant if they can’t offer any value-add in the off-renewal years. This will be an interesting dynamic to watch as major reinsurers look to add value that secures them greater shares when a program does come back to market.

For the major reinsurers, having access to risk through the relationships and large shares of multi-year placements, while also having the ability to tailor products to client needs, and access primary risk with better margins, could all mean the need to increase rates on standard treaties is less pressing than before, even while margins on that business remain thinner.

This is an adaptation of the traditional reinsurance business model which could mean the softer for longer scenario plays out for even longer than initially anticipated.

Then, what of alternative capital and the insurance-linked securities (ILS) market?

If smaller reinsurers are going to struggle to sustain lower rates, but the larger reinsurers do not have the cause to hike them as considerably as in the past, it could play into the ILS fund and collateralised reinsurance market’s hands.

ILS fund managers and investors have demonstrated their risk appetites remain strong at recent renewals and in recent catastrophe bond issues, with pricing levels still meeting their requirements for returns.

At the same time ILS managers have increasingly shifted up the value-chain, to source risk more directly and in ways that take it outside of the traditional renewal cycle, enhancing the margins on business underwritten and augmenting returns from the traditional treaty and cat bond business.

That again suggests that soft pricing can be sustained for longer, resulting in the stability that is expected perhaps becoming a stable normal in reinsurance, rather than a stable bottom of pricing, as many are hoping for.

Of course, none of that takes into account the capital levels in the industry and the appetite to deploy more of it, both on the traditional and the alternative or ILS side.

Large traditional reinsurers will take advantage of any opportunity to take a growing share in reinsurance and, if smaller players are going to struggle to sustain rates, why would they force pricing up considerably if they can sustain the levels while putting increasing amounts of capital to work?

At the same time the capital markets remain ready for any major opportunity to deploy more capacity, with sidelined investor capital likely dwarfing the amount already deployed in ILS and collateralised reinsurance.

If ILS players can also sustain these lows there is really no reason to suspect that wholesale reinsurance rate increases are to be anticipated. Rather any increases are likely to be (and should be) on a case by case basis and largely based on risk commensurate pricing, rather than margins of less efficient business models and payback.

Could we see a dynamic where by the major reinsurers become more important, and the capital markets get to go along with them, both as support and efficient capital partners?

That is an interesting prospect and as dynamics go in the reinsurance and insurance market, a highly expertise-driven group of global re/insurance players and a growing, specialist and capital efficient ILS market could result in a market dynamic which in time became more healthy, stable and ultimately profitable for all.

How major reinsurers and the capital market’s interface could drive a more profitable future in reinsurance, both for them and ILS players, with another level of convergence as yet not fully visualised one potential outcome.

While pressure on reinsurance rates may be unsustainable and pricing has to find a bottom (hopefully risk commensurate in nature), the changes to market dynamic that have been seen in recent years point towards a cycle never witnessed before, which ultimately could be more beneficial to the insurance consumer.