Some reinsurance lines are no longer meeting cost-of-capital for the world’s largest reinsurers, which sees the firms often writing business at levels which are technically unprofitable as they subsidise some risks as diversifiers.
Yesterday, Hannover Re executives explained that its catastrophe excess-of-loss underwriting portfolio was no longer anticipated to meet its cost-of-capital, while in specialty lines aviation is also less profitable now.
This morning Munich Re echoed this, saying that in lines such as offshore marine reinsurance it was already writing business at levels below its cost-of-capital, while some catastrophe lines in Europe and other diversifying areas are also unprofitable, as standalone risks.
Now, reinsurers have long used certain poorly priced risks as diversifiers, essentially subsidising their underwriting in order to maintain a foothold in lines of business or regions, or to add diversification to their overall portfolios. But even so, this hasn’t always been at levels below cost-of-capital.
The requirement to ensure a certain level of return on capital deployed is one of the major differences between a traditional reinsurance firm and an ILS manager, in how they approach the market.
An ILS manager has investors with a return requirement, and also does not have the ability to generate profits on investment returns on its float, hence underwriting at levels near or below cost-of-capital is inadvisable, except perhaps for the very largest and most diverse ILS players.
At a reinsurer, where the portfolio is so large and diverse, that one business line can be subsidised by another, or diversification benefits can be taken into account more readily, the ability to underwrite at levels close to cost-of-capital is more readily acceptable.
Add the fact that traditional reinsurers can make a return on their premium float, where as a collateralised or ILS market sees its underwriting capital locked up in trusts for the duration of contracts, and traditional reinsurers have a little more leeway to flirt with cost-of-capital than the capital market players.
However, flirting with cost-of-capital and actually underwriting business that no longer meets it are two very different things.
In response to the admissions by Hannover Re and Munich Re, that there are parts of their business that are no longer generating underwriting profits, some of the analysts have voiced concerns, questioning the sustainability of this practice and what risks it could put on the balance-sheet.
Ulrich Wallin, CEO of Hannover Re explained during yesterdays analysts call; “Overall we still expect to earn the cost-of-capital based on risk free interest rates.”
However the reinsurer clearly finds some areas more profitable than others, saying that North America comfortably makes cost-of-capital, while Europe is getting closer to becoming an unprofitable underwriting region.
In specialty risks Hannover Re said it expects marine reinsurance will remain profitable, which is interesting given this is an area that Munich Re said it was not meeting cost-of-capital anymore, perhaps reflecting differences in the two reinsurers portfolios and strategies in this area.
“In aviation cost-of-capital will be difficult to earn,” the firm’s executives explained during the call, before adding that catastrophe excess-of-loss underwriting is already at levels below cost-of-capital.
If catastrophe loss experience matched modelled loss expectations then the natural catastrophe reinsurance business generally may not earn a reinsurers cost-of-capital, the discussion on the call suggested.
Hannover Re denied that they would write at levels below cost-of-capital in catastrophe reinsurance just to generate other business from clients. Instead they said that while the client relationship is importance it shouldn’t reflect on pricing and that they do this to maintain a foothold in that market.
Hannover Re has steered its catastrophe reinsurance portfolio away from the least profitable business and also reduced it as a share of its overall underwriting portfolio, rather than just canceling all its catastrophe renewals and then missing out on profits in a benign loss year, as we’ve seen recently.
That perhaps says it all, to a degree, that catastrophe business remains profitable while losses remain benign. Once losses tick up and you’re not meeting cost-of-capital the impact to profits could be quite steep and very noticeable in reinsurer results.
Hannover Re’s view is that the reinsurance market remains a cyclical one and that rates will increase quite significantly after a loss, let alone a major loss, the executives said on the call. This causes the reinsurance firm to want to maintain a catastrophe portfolio, but all the while managing and steering it towards a lower market share and the more profitable opportunities.
If there is a major loss, or a market dislocation, Hannover Re will seek to increase its market share significantly, the executives explained, which it believes it has a good base for by maintaining its stake in the catastrophe reinsurance market. However, while the reinsurer could have written more, as there is no lack of opportunities being supplied, it currently chooses not to.
One thing Hannover Re said it would never do though, is underwrite at levels below the modelled expected loss. The executives explained that for Hannover Re the walk away price is expected loss, plus expenses, plus retrocession expenses. Anything below that and it will not renew the business, they explained.
Meanwhile, this morning Munich Re executives explained that there are areas of the market where it can no longer earn its cost-of-capital, which in the majority of cases caused the reinsurer to withdraw from those lines or areas, but in some cases the firm subsidised the business, again likely to maintain a position.
One reason Munich Re subsidises business is in order to maintain a relationship with a client that it believes it can make more money from over the longer-term. Other reasons are likely diversification and the same as Hannover Re, to be positioned for any change in rates.
Munich Re said that the offshore marine reinsurance business is already below its cost-of-capital. While in catastrophe risks it said that the U.S. is still profitable, but Europe and other regions are becoming less so.
It’s no surprise that analysts have voiced concern at hearing companies are already not meeting their cost-of-capital in some part of the reinsurance market. It suggests diminishing returns are ahead, particularly once losses tick up at all.
With the big reinsurers returns on equity declining, as we wrote earlier is the case with Munich Re, the investment analysts are likely to take a dim view of any activity which could exacerbate the ability to generate returns.
If these two major reinsurers are experiencing this you can be sure that all the small to mid-sized players, which are more greatly exposed to market forces and competition, are also writing at levels below cost-of-capital.
This is why some reinsurers are ploughing ahead into third-party capital management, where efficient capital markets money which often has a lower return requirement than a reinsurer balance-sheet can be used to maintain and grow into less profitable areas of the business. Of course this is also why ILS fund managers have been taking growing shares of property catastrophe reinsurance markets.
But of course the great unknown in this equation is what happens to reinsurance rates after some larger losses occur?
Is Hannover Re right and will the reinsurance market return to its old, cyclical self, or will influxes of alternative capital and ILS money help to dampen any expected price rises? Or in fact has the cycle been changed structurally for good and might we never see those types of price rises, such as were seen in the mid-2000’s, ever again?
If the reinsurance market is truly undergoing a structural change that will, or perhaps already has, alter the market cycle for good, is operating a business on the hope that the market responds as it used to a sensible strategy?
It’s easy to talk up the possibility of huge rate increases after large events. But should $50 billion, or perhaps $100 billion, of new alternative capital flow rapidly into the sector, what happens then to those that struggled to meet cost-of-capital when prices don’t rise as far as they perhaps need to justify their strategy and indeed pay the losses they will face?
Of course, much of this comes back to the concept of being paid back for taking on a clients risks and taking the good years with the bad. Reinsurers still clearly expect payback, including for having taken on risks at unprofitable return levels. The question is whether the market cycle responds as they clearly hope and will actually enable them to achieve this?