The effects of the softening reinsurance market are increasingly becoming evident and rating agency Standard & Poor’s highlights that reinsurers stand to suffer much greater earnings volatility as their performance becomes more sensitive to large catastrophe loss events.
For some time we’ve been discussing the fact that as the reinsurance market has softened the underwriters have been accepting increasing amounts of risk, at declining levels of return and that this will come back to bite the market should major losses occur.
S&P, in a new report, says that just an uptick to average levels of catastrophe losses could result in some reinsurers facing earnings volatility, suggesting the effects of the soft market are becoming more acutely felt and that for some reinsurers there will be nowhere to hide when the worst happens.
Reinsurance firms have been reporting performance that has been deemed more than reasonable, given the prolonged soft market environment, but it seems that some have perhaps been living on borrowed time, as their earnings are now more exposed to any slight uptick in catastrophe loss activity than before.
S&P says that reinsurers have not generally increased their balance-sheet exposure to extreme natural catastrophe events, but that the soft market means that their earnings exposure has increased, from 0.69x to 0.85x.
This increase in earnings exposure means that a catastrophe event will now have an outsized impact on reinsurers, compared to a few years ago, as more of their earnings are exposed to losses than before.
As a result, reinsurers are now considered twice as likely to report an underwriting loss due to a natural catastrophe event than they would have been in 2012.
That’s a stark fact, double the risk of loss in just five years of softening market, as reinsurers have picked up increasing amounts of exposure at reducing levels of return.
“Global reinsurers’ exposure to unpredictable and high-severity natural catastrophe events is a major driver of reinsurers’ earnings and capital volatility, and while we are seeing capital at risk reduce slightly as a percent of equity, earnings exposure is up,” commented S&P Global Ratings analyst Charles-Marie Delpuech.
Earnings volatility is likely to “intensify” should industry annual catastrophe losses approach the long-term average, S&P explains.
In fact, the earnings exposure is now so high that S&P has now said that seven of the 20 reinsurers the company rates could suffer an erosion of their capital base after an annual aggregate loss in the 1-in-10-year return period range in 2017.
1-in-10 year events are not major industry losses, these are the kind of catastrophe losses a reinsurance company would be expected to deal with relatively frequently.
The exposure to this level of event has seeming increased dramatically in the last year, as S&P says that only a year ago the rating agency would not have seen any of the reinsurers it rates to be at threat from such a loss event.
S&P says that reinsurers capital remains strong, which is providing a buffer to the industry in case of losses, but the rating agency notes that some reinsurers are becoming increasingly at risk, more exposed to lower return period losses and more sensitive to catastrophe risk than before.
It’s the combined effects of the soft reinsurance market, that reinsurers have been taking on risk at lower returns (which naturally puts earnings more at risk), but there is also the effect of taking on more risk at lower return and at increasingly broad terms and conditions, which can also exponentially increase the level of exposure assumed.
Add in the competition factor, that reinsurers have had to get their capital deployed at these lower rates and less attractive terms in a market environment where the biggest players can wield their diversification to compete harder, and there is competition coming from players with an efficient capital model and ability to underwrite at lower returns (the ILS and capital markets).
Consecutive years of underwriting in such an environment is bound to ramp up the exposure assumed and now S&P is warning the sector that some reinsurers exposure has risen to the point that a catastrophe loss event they would be expected to soak up in any normal year may now cause significant damage to their earnings.
“Given that prices are continuing to soften across all lines of business and global property catastrophe prices were down about 4%-6% during 2017 renewals, we consider more-frequent catastrophe losses will become a bigger threat to
underwriting profits and capital than they were in the past,” Delpuech continued.
The most exposed to property catastrophe risks may need to address their appetite for assuming such risks, S&P advises, in order to protect their earnings, capital base and competitive position.
As this catastrophe threat to reinsurers rises, which it will as the soft market persists, Delpuech said that; “Reinsurers are therefore likely to see heighten volatility in earnings.”
S&P expects that reinsurers will attempt to manage the increasing catastrophe exposure through the use of retrocession protection or by reshaping their portfolios.
But, as the margin continues to be eroded out of the reinsurance business for a traditional players business model, any uptick in catastrophe losses is anticipated to become an increasingly large threat to underwriting profits and reinsurer capital.
Should reinsurers try to hold onto their current exposure levels they are likely to see increasing volatility, according to the rating agency, which suggests that some companies are approaching a point of no return, where they have little choice but to begin to de-risk more dramatically, leverage more retrocession, or to share more risk with the capital markets.
That could result in further opportunity for the capital markets and insurance-linked securities (ILS) investors, as reinsurers carrying too much exposure look to de-risk.
We could also see new third-party capital vehicles established by traditional players, as they look to leverage the support of efficient capacity from the capital markets to both augment their own underwriting and also to reduce their exposure to the peak catastrophe events.
Of course, the ILS fund managers are also facing rising exposure as well. Most ILS fund strategies now take on more risk for less return than we saw five years ago, but the ILS business model could be better suited to maintain underwriting in the current soft environment, as long as managers are also dealing with any peak exposure through hedging.
As the soft market persists, which seems likely, reinsurers are going to face earnings pressure from smaller catastrophe events than might have been expected a few years ago.
How will their shareholders react should that happen? How too will the reinsurers bounce back if market conditions fail to harden, as the loss events that impact them increasingly severely just haven’t been severe enough to turn pricing around?