Analysts at Morgan Stanley predict that reserve releases will progressively decline in the coming months and years, contributing to as much as a 6% decline in P&C insurance and reinsurance earnings.
Morgan Stanley has issued a warning to property and casualty (P&C) insurance and reinsurance firms following the recent high levels of reserve releases, a trend that has been driven by firms seeking to bolster results as low inflation, benign losses, competition, and ultimately depressed rates contribute to low profitability.
Analysts from the firm warned earlier this year that the reserve releases for P&C reinsurers are expected to shrink through the next few years, contributing to a declining portion of companies’ operating income.
“On average, over the last five years reserve releases made up 17% of operating profit and averaged 3.6% of the combined ratio. Our base case is for reserve releases to gradually decline (rather than see more reserve strengthening),” said Morgan Stanley in a recent report.
The report states that reserve releases at property and casualty insurance and reinsurance companies are expected to decline to 2% by the year 2020, from 3.5% in 2015, and that this will translate into a 6% decline in earnings.
With reinsurers already under pressure to maintain, or improve underwriting profitability at times of volatility in the investment market, reserves have been seen as away to boost quarterly results.
However, owing to a continued lack of large loss events reinsurers’ reserves have been seen to be shrinking, albeit with some firms having a larger reserve buffer than others.
Interestingly, Morgan Stanley notes that the majority of reserve releases in 2015 came from the 2012-2014 accident years, which analysts explain highlights cautious comments – “that the most recent accident years are set less conservatively, so they have a smaller buffer to release from.
“The low inflation environment has helped, in our view, but we would caution the potential for insurers to release reserves earlier in order to boost current year profits,” said Morgan Stanley.
The firm predicts that the reserve releasing trend could end in two ways, a decline reserve releases that will result in lower earnings over the next five years, or further reserve charges being taken.
However, the latter point could “help the pricing environment,” explains Morgan Stanley.
“As in the early 2000s, many insurers had to take reserve charges relating to the 1997- 2001 underwriting years for workers’ compensation lines. This eventually led to the hard market in 2001-04,” said Morgan Stanley.
The shrinking of reserves again highlights the continued need for underwriting discipline and sophistication in the current pricing environment.
An ability to remain profitable or sustainable during the challenging market landscape and refrain from aggressive reserve releases will benefit firms when losses do normalize, or the next large event happens.
Firms that aggressively release reserves to mask true profitability could see their reserves become dangerously low, and with low inflation and the continued benign loss landscape the opportunity to replenish could diminish also.
Should any reinsurers find themselves in this position when a large loss event happens, which it undoubtedly will at some point, and then results could start to turn pretty sour, pretty fast for some.
Of course, a 6% decline in earnings would mean that some companies could find themselves heading for negative territory very quickly, especially as some estimates suggest that returns on equity for reinsurance firms could be as low as 3.4% on a normalised basis with an average loss load.