Rating agency Standard & Poor’s has come out with its strongest worded statement to date on the rating outlook for the global reinsurance market, saying that increased competition and soft reinsurance pricing could lead to rating pressure for reinsurers.
After eight consecutive years where Standard & Poor’s (S&P) has forecast a stable outlook for the global reinsurance sector, 2014 sees a change as the impact of oversupply of reinsurance capital, from traditional and non-traditional sources, ramps up competition at a time of softening rates.
As a result of all this capital and competition, S&P believes that it will see a negative trend in ratings for reinsurers in 2014. The market reached a tipping point in early January, once the results of the reinsurance renewals and the extent of price softening witnessed were better understood, and S&P’s outlook for the sectors ratings has become more negative.
The competitive behaviour that S&P has witnessed between reinsurance companies at the renewals will weaken profitability in 2014 and 2015, said the rating agency. In S&P’s opinion these competition related risks are now the most prominent threat to the reinsurance sector, outweighing the macroeconomic risks it highlighted in September 2013.
Dennis Sugrue, Director of Insurance at S&P in Europe, told Artemis; “We observe that the shifting competitive landscape and the material reduction in premium rates will significantly impact the sector’s capital and earnings, and could lead to some negative rating movements over the next 12 months for certain reinsurers.”
This is the first negative outlook on the global reinsurance market from S&P in eight years, which shows just how big a threat the trends Artemis has been covering in recent years have now become. The sector is awash with capital and institutional investors would like to deploy more capital into the space if the opportunity presents itself.
At the same time reinsurance companies are learning to manage third-party capital and how to add this capital into their underwriting mix. This is raising the competition between alternative and traditional reinsurance capital, but it is also raising the competition between these types of capital for business within these companies too.
The end result can only be an impact on profits as recent trends in the reinsurance market shake out. The lower cost-of-capital associated with insurance-linked securities, collateralized reinsurance, catastrophe bonds, sidecars and other third-party capital backed structures means reinsurers are, in some cases, cutting their own profit margins.
At some point the issue of expense ratios will become much more prominent in reinsurance and in reinsurers financial reporting, as reduced profits could make certain reinsurance companies look like relatively inefficient homes for investors capital.
Capital, competition and a soft reinsurance market have converged to bring the reinsurance sector to a tipping point where the outlook now has more downside than upside. Dennis Sugrue commented; “For the first time since 2006 we are expecting to see more negative rating actions in the sector than positive ones. ”
S&P estimates that close to half of its global reinsurance ratings are exposed to these pressures, adding that any companies exposed who find it difficult to navigate the market environment could find themselves facing negative rating actions.
Reductions in premium rates will hold back reinsurers earnings in 2014 and 2015, according to S&P, meaning that it expects reinsurers results will be lower than they have been on average for the past five years. Added to the competitive threats, this could result in revised credit scores for some and ultimately may lead to consolidation or negative rating actions for a few.
Capital is continuing to rise in the reinsurance sector, with the inflow of alternative capital from catastrophe bonds, sidecars and ILS a contributing factor. Returning capital to shareholders will only partially offset this, said S&P, it anticipates that the reinsurance market will retain almost two-thirds of its earnings.
Reinsurers struggle to deploy excess capital profitably in other areas, while ILS and alternative reinsurance capital is now having a spill-over effect as it moves into markets outside of the U.S. and this is putting pressure on pricing outside of U.S. property catastrophe reinsurance.
New opportunities, such as moving into emerging markets, are not keeping pace with the growth of reinsurance capital. The result is pricing pressure which is broadening, S&P said that it is no surprise that reinsurance capacity is getting cheaper in the current environment.
Buying patterns have changed, said S&P, with increased retentions and a greater demand for flexibility, comprehensive covers and bespoke reinsurance. As a result S&P said it is beginning to see a divide in the market, as reinsurers with the size, scope and expertise to offer tailored solutions reaping the benefits. For those reinsurers on the wrong side of this divide there is a struggle to stay relevant.
While rates were broadly down at the January reinsurance renewals, there was no widespread relaxation of terms and conditions, said S&P. But price declines and pressure for relaxed terms show that the underwriting cycle is very much alive. There is some concern about the relaxation of underwriting standards at S&P, if terms and conditions become too loose.
Dennis Sugrue, said; “Although, we recognize that reinsurers maintained their stance on current terms and conditions at the Jan. 1 renewals, we believe that recent talk of looser terms and conditions could spell the beginning of a shift away from the sense of reinsurer unity in underwriting discipline that we have perceived in recent years.”
Consolidation and mergers or acquisitions are likely to be much higher up the agenda of reinsurance management teams over the next year, according to S&P. Mid-tier reinsurers may look to acquire to grow and increase scope, while smaller reinsurers may see consolidation as an option to enable survival. S&P said that as reinsurers look to grow, acquisition may be the most attractive option due to unfriendly market conditions.
S&P has noted the decline in catastrophe retrocession pricing, something Artemis covered recently here, saying that it has materially outpaced declines in catastrophe reinsurance pricing. Pricing pressure in the retro market is largely driven by capital from ILS funds, cat bonds, sidecars and other third-party capital vehicles.
This presents an opportunity over the short-term, with reduced pricing available for reinsurers seeking protection, but it will only partially offset the reduction in income. However, those reinsurers who look to take advantage of this, perhaps passing risk to the retro players in order to underwrite more reinsurance business may not find it a viable strategy.
Dennis Sugrue explained; “We believe there will be a temptation for reinsurers to take advantage of arbitrage opportunities and over-rely on retrocession to manage exposures. It’s not beyond the realms of possibility that a reinsurer could effectively become a conduit for passing risk from the insurance market to the retrocession market. In our view, this would significantly undermine a
reinsurer’s competitive position.”
S&P forecasts a deterioration in the reinsurance sectors operating performance in 2014, compared to previous years, especially 2012 and 2013. While it does expect the majority of reinsurers will continue to generate acceptable returns, the risk of underperformance is elevated.
S&P forecasts a combined ratio for the reinsurance sector of 95%-100% for 2014, and 98%-104% for 2015. It bases this on average rate reductions of -3% to -8% across all lines of business, modest premium growth an average catastrophe load of 10%.
Reinsurers are expected to rely even more on reserve releases from prior years to maintain recent operating levels, but this could be an issue for carriers who have been less conservative in booking their reserves on recent accident years than they had before. Reserve release benefits are set to diminish in 2014 and 2015, said S&P.
A reinsurance sector wide return on equity of 7% to 9% is expected in 2014, with a slight improvement due to a better investment outlook in 2015 which will help to alleviate some rate reduction.
Reinsurance companies with a strong catastrophe focus are likely to be the worst affected, said S&P, being most at risk of underperforming. S&P will monitor these reinsurers ability to resist competition and pricing pressure and will track their earnings and capital closely over the coming months.
There is also a risk that some reinsurers are taking on more risk for lower reward, which could result in erosion of capital due to increased exposures faster than income and investments grows the balance sheet. Any large catastrophe losses in 2014 could be something to watch, according to S&P, as they might contribute to higher volatility in capital and earnings than in recent years.
So, the evolving reinsurance market is resulting in less opportunity for profit and growth as well as the potential for materially greater risk bearing and impact from large loss events. This puts certain reinsurers in a precarious position which will play out over the coming year or two.
Dennis Sugrue explained; “We think that companies without a defendable competitive position or those who are more aggressive in maintaining market share by competing on price or relaxing their underwriting discipline, are most at risk. If we observe that a reinsurer’s product mix or risk profile indicates unfavorable competitive undercurrents, relative to other global reinsurers, we could revise our assessment of its business risk profile to reflect the relatively higher risk.”
Any reinsurers with a lower capital buffer or companies that appear to have constrained earnings could face a difficult future, said S&P. The smaller, catastrophe heavy reinsurers are most under pressure in S&P’s view, with their margins likely to be hardest hit and under the most competition.
Also reinsurers who take on greater levels of risk, with no increase in premiums, either by underwriting more business at lower rates or by relaxing terms and conditions, could see their risk positions getting noticeably worse.
With nearly half of the rated global reinsurers that S&P monitors at risk from these pressures, the rating agency will be focusing on underwriting discipline, rate adequacy and profitability as it monitors these firms over the next year or two. Many will successfully navigate these challenging times, said S&P, but those on the margins or who relax their rigor could be exposed to consolidation or negative rating actions.
S&P’s report on global reinsurance market pressures can be purchased or accessed by S&P subscribers here.