Covid-19 means reinsurers won’t make cost-of-capital in 2020: Fitch

The global reinsurance market will fail to make returns above its cost-of-capital due to the impacts of the Covid-19 coronavirus pandemic, Fitch Ratings has said following a review of ratings in the sector.

Cost-of-capital has been something the reinsurance sector has been struggling to earn for a number of years now.

Around five years or so ago, some lines of reinsurance business began to be seen as unprofitable, given the persistent softening of rates seen.

This resulted in reinsurers getting closer and closer to delivering returns that wouldn’t compensate their costs-of-capital, and for 2019 broker Willis Re said that the underlying results of the reinsurance market and the return on equity (RoE) of the subset of reinsurers it tracks had declined further, falling well below the industry’s cost of capital.

It looks like 2020 will deliver the same, but perhaps much more broadly across the reinsurance sector thanks to the impacts and losses caused by the Covid-19 coronavirus pandemic.

“Financial performance will be hit by mortality claims and losses from event cancellation, business interruption, credit and surety insurance, as well as by financial market disruption linked to the economic impact of lockdown measures. This follows three years of heightened natural catastrophe losses and increasing US casualty claims, which depressed reinsurers’ returns in 2017-2019,” Fitch Ratings explained.

Fitch reviewed global reinsurers’ ratings in light of the pandemic during April and May, assessing their pro-forma financial metrics and comparing them to its rating guidelines.

The review resulted in negative rating actions being taken on six of the 22 reinsurance groups reviewed by Fitch, with two one notch downgrades, three affirmed but revised to negative and one reinsurer placed on rating watch negative.

Deteriorating financial performance was the main driver of these rating changes for global reinsurance market participants it seems, but of course this performance was already dwindling even before the pandemic came along.

Despite the impacts of the pandemic though, Fitch explained that, “We continue to view the global reinsurance sector’s capitalisation as strong on average, with pro-forma capital ratios not much weaker than those at end-2019. We expect capitalisation to hold up in most cases and not be a major driver of rating actions.”

Tailwinds are improving for the reinsurance sector, of course, with rates firming to hardening broadly at this time.

Which suggests that the all-important underwriting returns of the reinsurance market should rise, but the question will be whether this can compensate for the immediate and likely ongoing losses and financial impacts from the Covid-19 pandemic.

In addition. Fitch notes that while primary insurance premiums may decline due to the economic hit from the pandemic, it expects the market will see “increased demand for reinsurance coverage from primary insurers stung by pandemic-related claims.”

While on pricing, “Reinsurance prices are likely to rise as a consequence of slightly weakened sector capital, which should largely offset declining investment income due to lower interest rates.”

Summing up, Fitch said, “The ultimate implications of the pandemic on global reinsurers’ credit profiles are uncertain, but the risks are skewed to the downside for companies that cannot earn their cost of capital on a sustainable basis given the long-term negative implications for their capital positions.”

Failure to make cost-of-capital sized returns has not been an issue for the reinsurance market historically, but under the shadow of the pandemic and with claims expected to continue to flow from this, the impact to some players could be more significant.

Which may drive further use of third-party capital and continued hybridisation of certain reinsurance company business models.

By leveraging capital that has a lower-cost attached, it may be possible to make more margin out of the business you underwrite.

As we’ve said many times, what is absolutely key for the long-term stability of reinsurers is that underwriting returns and rates are covering their loss costs, cost-of-capital, operational expenses and supplying a margin.

Without this it is increasingly hard to see sustainable profitability for the reinsurance sector over the longer-term, especially for the small to mid-sized players.

This need to cover loss costs, cost-of-capital, expenses and a margin goes for insurance-linked securities (ILS) players as well, of course.

But with alternative capital and ILS investor commitments coming with a lower-cost attached, while the business model can be more efficient as well, it does give ILS capacity an edge in certain cases.

Reinsurers get their edge back through leverage and the input from the investment side. But in the current globally volatile and uncertain environment, there are no guarantees how sustainable returns will be.

All of which might make lower-cost underwriting capital increasingly attractive, no matter how much reinsurance rates harden.

Which is why we forecast an increasing prevalence of partnerships between investors and reinsurers, greater use of third-party capital to augment underwriting capabilities and also further growth of ILS capital in general.

One lever that could turn the tables in the favour of the traditional reinsurers could be on the expense side, as there are really significant gains in efficiency that could be made.

But it seems likely the gains here will be slower to be accrued and at the same time strategically different players are also making efficiency gains in the same way.