Bermuda reinsurance market profitability nears cost-of-capital: Fitch

The Bermuda reinsurance market has seen its margins drop again, as prices and investment yields remain pressured with profitability now approaching cost-of-capital, according to Fitch Ratings.

Reflecting the importance of capital efficiency, and increasing the likelihood that Bermudian re/insurers will become ever more reliant on lower-cost, third-party capital sources, the gap between returns on equity (RoE’s) and estimated cost-of-capital remains narrow.

Fitch Ratings believes that while the majority of Bermuda insurance and reinsurance company ratings should remain stable over the next year or so, there could be negative actions for some players should pricing adequacy decline materially further.

We’d expect that focus to be on the companies which have the narrowest margin between returns and cost-of-capital, as these are the companies who are only barely breaking even right now.

Underwriting weakened in 2016, as combined ratios increased among Bermuda re/insurers due to the highest catastrophe loss experience in a few years. The average across the 12 Bermuda publicly traded companies that Fitch Ratings tracks came in at 91.9%, up from 88.5% a year earlier. Large cat loss impact more than doubled, from 2.5% in 2015 to 5.4% in 2016.

Reduced underwriting income was offset by better investment performance to a degree, meaning that average return on equity was stable at 8.2% in 2016, Fitch explained. However the cost-of-capital estimate at 6% to 7% means that the profit margin remains slim.

“Bermuda companies posted weaker underwriting results and steady profits in 2016; however, returns are starting to near the cost of capital and narrowing profit margins are a key risk,” commented Brian Schneider, Senior Director in Fitch’s Insurance team.

In such an environment the ability to maintain an underwriting profit is vital, which may result in even more impetus for Bermudian re/insurers to leverage third-party capital to finance underwriting, while they extract fees and service related income instead.

This could make reinsurance sidecars an increasingly popular option, as a way for re/insurers to continue to underwrite in markets where their own cost-of-capital makes their capacity inefficient in the currently soft priced market.

Additionally, third-party capitalised reinsurance vehicles that follow a more active investment strategy, so the total-return reinsurers such as ABR Re, Watford Re and KaylaRe, could prove increasingly attractive ways to maintain underwriting volumes, while earning some income and using an additional balance-sheet backed by capital market investors.

For some time now we’ve been saying that as reinsurance market pressures persist companies are going to need to find the best ways to get paid for using their intellectual capital. For a re/insurer this is sourcing, analysing, pricing and underwriting risk, but not necessarily (for every line of business) wielding an equity backed balance-sheet.

If re/insurers can get paid for all of the expertise they bring to the underwriting process, while using third-party investors capital, it could enable them to maintain a level of profit in some areas of the market where thin margins no longer make it profitable using their own capital.

As profitability sits barely above the cost of a re/insurers own capital, it can sit further above the cost of third-party capital, making launching sidecars, ILS funds, total-return reinsurance vehicles, or partnerships with existing ILS fund managers an increasingly attractive opportunity.

Fitch Ratings says that the narrowing of profit margins is a key risk for reinsurers, but with capital levels still high in traditional reinsurance, and capital returns remaining firmly part of the strategy, it still looks like we need some kind of event, or dislocation, to cause the kind of market stress that would really hurt Bermuda’s reinsurers.

But even while the market avoids a major event or dislocation, the diminished margins will push more and more companies to leverage third-party capital sources, in some form or another, which could offer some interesting opportunities for capital market investors over the coming months.