Rating agency A.M. Best questions the relevance of the reinsurance underwriting cycle in its latest special report on the sector, asking whether the cycle has grown distorted thanks partly to the growth of ILS and alternative reinsurance capital.
The growth of so-called convergence capital, from institutional capital market investors in insurance-linked securities (ILS) such as catastrophe bonds and collateralized reinsurance, has triggered behavioural changes among the reinsurance market’s traditional players, says A.M. Best.
The additional competition from lower-cost ILS and alternative capital is forcing or stimulating reinsurers to adapt their strategies or business models. As a result, A.M. Best is seeing evidence of changes to their behaviour, such as some reinsurers appearing for the first time on reinsurance programs in regions of the world where they would typically not be seen.
This is further evidence of the structural change that the reinsurance industry is undergoing currently, as the realisation that reinsurance margins are reduced and may stay depressed for some time hits home. As this new reinsurance market environment of excess capacity, both traditional and alternative, higher competition and lower rates continues, we expect to see concerted efforts from traditional players to find new avenues to boost their overall returns.
A.M. Best points out that despite the fundamentals of the reinsurance market trending generally in the wrong direction, which led it to change its reinsurance sector outlook to negative recently, capital continues to be attracted to the space.
The insurance cycle has historically been driven by supply, demand and the occurrence of large catastrophes or other types of loss event. Too much capacity in the market and pricing typically comes down, as we see today thanks to the growing figure of traditional and alternative reinsurance capital. At some time the downward price decline typically reaches a floor and balance sheets display a need for repair.
When large catastrophic events bring heavy losses to the insurance and reinsurance sector it can create an upward pressure on rates and prices. Today of course we have seen a few years of below average cat losses which have exacerbated the growth of capacity.
The additional factor in the current cycle of softness is the continued growth of alternative reinsurance capital in the market. At an estimated $59 billion and up 18% in just the first-half of 2014, this capital is deemed here to stay (largely) no matter what the catastrophe gods throw at it.
This additional factor has the potential to change the re/insurance cycle, as it is now changing reinsurers behaviours. ILS and alternative capital is typically considered lower-cost, meaning it appears to have a lower return requirement for certain types of property catastrophe reinsurance business, which as a result means it may not pressure for the rate increases that traditional reinsurers would when the cycle would be expected to turn upwards.
This softening of the reinsurance cycle is something we’ve written about for a few years. So far it lacks real evidence, as we have yet to see an event or financial market happening that could force rates north. However an increasing number of the rating agencies and observers agree that reinsurers may not be able to recoup losses in the future in the same way they have typically been used to.
Part of the re/insurance cycle has always been an insurer or reinsurers desire to be ‘paid back’ for taking on the risks it underwrites. When a major event occurs, rate increases in reinsurance can be huge percentages, much larger than any increase in perceived risk would actually suggest. One of the impacts of ILS and the appetite of alternative reinsurance capital may be to make this getting paid back more difficult to achieve.
So this could result in shorter hard markets, perhaps longer soft markets and a generally flattening of the peaks and troughs that reinsurers have been used to. At least in lines of business where the competition and influence of new forms of capital are most evident, such as U.S. property catastrophe risks.
Of course a very major event of $100 billion plus may still stimulate some hardening and an ability to claw back some losses, it’s likely that ILS managers would appreciate this too. However the expectation that more capital may enter the market should this happen suggests that the peaks may not be as high as we’ve seen before.
A.M. Best cite the example of Paul Ingrey’s ‘underwriting clock’ which shows twelve segments of the insurance market cycle, like hours on a clock, as a model that provides a useful way to think about reinsurance market cycles and how they could be affected by current market trends.
A.M. Best muses:
Some say that hard markets are shorter lived these days, given the speed at which capacity can quickly enter and exit. Some believe the soft market’s trough won’t be as deep because catastrophe and pricing models help put a floor under premium rates. People may point to numerous reasons as to why this period of time may be different, while others may believe the clock needs recalibrating. Whether Ingrey’s insurance clock is distorted is debatable, but A.M. Best believes that this clock is still ticking. While nobody knows exactly how this will end, at some point it will be possible to view this cycle through a historical lens and truly see if this time was different. Keep in mind Mark Twain’s famous quote, “history doesn’t repeat itself, but it does rhyme.”
The continued inflow of convergence capital, into the range of ILS instruments and hedge fund reinsurers, has triggered behavioural changes in reinsurers, says A.M. Best. What was once a trickle of capacity into peak property catastrophe risks is now displacing incumbent capacity into other business lines and geographies.
A.M Best, with its broad coverage of the global insurance and reinsurance market, says that it now sees company names appearing on reinsurance programmes for the first time in atypical geographies. This suggests that reinsurers are looking to any opportunities where they can avoid the most competitive lines and regions of the world.
If and when reinsurers are expanding to regions that are new to them, expertise may be an added cost to their underwriting capital. The same is true of entry into new lines of business, especially if underwriting talent is hard to source. This has been worrying insurance equity analysts for some time, as something that may come out in the wash in quarters to come.
As with ourselves and other market observers and analysts, A.M. Best says that it is very difficult to forecast the outcome of recent trends in reinsurance. Who will be the winners in the current market environment, whether alternative capital will be sticky or grow even further, who may have bitten off (underwritten) more than they can chew, all will be revealed in good time.
A.M Best explains:
The market continues to be at an inflection point, and this will be a process. While there will be winners and sinners among the players and more capital in the (re)insurance market, the ultimate winner over the near term will be the reinsurance buyer. Through that lens, this is all positive. But it is the long-term proposition that really matters for all the parties involved and that outcome is still very unclear.
So we have reinsurance companies exhibiting changes to their behaviour and a reinsurance market cycle which may not ever be the quite the same as the traditional market is used to. Couple that with higher levels of competition, new more efficient risk transfer products being developed, technology beginning to change the way re/insurance business is underwritten, pricing down, terms and conditions increasingly relaxed, with the resultant lower margins and greater volatility in earnings and this market is undergoing significant change. Structural change for certain.
A.M. Best’s report, its latest Global Reinsurance Segment review, goes into some detail behind its reasoning for the move to a negative sector outlooks as well as why it doesn’t yet feel that a significant number of reinsurer downgrades are ahead. It maintains a long-term, 12 to 18 month view for the moment, saying that the sector rating is likely to remain negative for that time at least.
The report takes an in-depth look at recent catastrophe bond issuance and third-party reinsurance capital activity, how the top 50 reinsurers in the world are maintaining market share for the moment, the top 10 threats to reinsurer financial strength of which one is alternative capital that we covered previously here, Lloyd’s of London performance, how Asian reinsurers are responding, opportunities in other regions and performance data on the reinsurance sector.
As such the report contains a lot of information, some of which we’ve covered before. You can find a copy of the report via the A.M. Best press release here.
Also read our other recent coverage of A.M. Best market insights and reports: