Europe’s insurance and reinsurance sector watchdog, the European Insurance and Occupational Pensions Authority (EIOPA), highlights the continued and ongoing threat that current reinsurance market conditions pose to the traditional business model.
In its latest financial stability report, which was published on the 9th December, EIOPA explains that key to the future of the traditional reinsurer business model is the need to ensure “risk-adequate” pricing is attained at the upcoming January reinsurance renewals.
With reinsurers facing pressure from the continued interest in alternative capital and ILS investments, as well as the pricing pressure applied by excess capacity among the traditional reinsurance community and the benign loss environment, ensuring adequate returns are secured for underwriting is increasingly key.
EIOPA’s report explains; “There is an expectation that supply of reinsurance will continue to exceed demand for the upcoming January 2016 renewals. For that reason reinsurers’ profitability will remain under pressure.”
As a result the market needs to ensure it maintains a disciplined approach to acquiring new business. EIOPA warns on expansion of terms and pricing reductions, urging companies to ensure the rates they achieve are commensurate with the risks underwritten.
“Disciplined underwriting will be essential in order to compensate for low investment returns and a diminished ability to release prior year reserves. Against this background attaining risk-adequate prices at the January 2016 renewals is crucial for reinsurers,” EIOPA continued.
Reinsurers returns have been on a steady decline in recent years, as the market pressure has ramped up and EIOPA warns that while reported returns on equity may look adequate, they are inflated and the impact of market pressures has been masked to a degree.
“Reinsurers remain profitable, despite pricing pressure and the low yield environment. However the benign catastrophe environment has masked the full impact of falling rates within traditional reinsurers, as they have come under pressure from alternative capital providers,” EIOPA’s report states.
“On average reinsurers reported a ROE of 10.4%, versus 13.7% for the same period in 2014. However, these returns are inflated somewhat by the combined effect of reserve releases and low natural catastrophe losses.”
EIOPA notes that while combined ratios look to have fallen in the first-half of 2015, due to the low level of catastrophe losses, if analysed on an accident year basis excluding catastrophes combined ratios have actually risen, “reflecting downward pressure on prices.”
“It is estimated that more “normal” catastrophe losses would reduce the ROE to approximately 5%. In addition, there is a risk that excessive reserve releases by reinsurers will leave them vulnerable upon occurrence of a significant natural catastrophe event,” EIOPA continues.
Of course this scenario and the threat to reinsurance ROE’s make attaining risk-adequate pricing at the January renewals particularly vital, as well as a strong stance on expansion of terms. Any reinsurers taking on more risk at pricing levels that are not commensurate could be risking a very nasty shock when the next major loss events occur.
EIOPA explains the state of the market as January renewals approach; “Overall, the general environment remains largely unchanged. Rates continued to soften in 2015. Along with rate reductions the terms and conditions for reinsurance placements have improved further, e.g. expanded hours clause or improved reinstatement provisions.”
And while there are signs that price stabilisation is beginning to emerge, partly because of the fact that pricing in reinsurance is reaching so-called technical levels, while capacity remains abundant the need to be disciplined continues.
“Reinsurance capacity continues to exceed demand, reflecting a longer-term trend for primary insurers to retain more risk on their balance sheets. Competitive primary markets as well as low investment returns have forced insurers to be increasingly price sensitive, whilst their risk management capabilities have also developed over time,” EIOPA said.
The other area concerning EIOPA currently is insurer and reinsurers searching for yield due to the low rate environment.
“Low yields and the subsequent reinvestment risk remain the main concern in the European insurance sector, especially for life insurers,” EIOPA explained, which is stimulating the “search for yield” among insurance and reinsurance players.
Of course this has also helped to promote the ILS and reinsurance-linked asset class, making the low-correlation, steady and relatively stable returns of ILS assets look increasingly attractive to major capital market investors.
So the low-yield world pressures reinsurers on both sides, affecting their ability to maintain investment returns, encouraging them to increasingly embrace alternative asset classes, while at the same time contributing to the ramping up of competition from ILS and alternative reinsurance capital.
Gabriel Bernardino, Chairman of EIOPA, summed the situation up by commenting; “The persistent low interest rate environment is affecting the solvency position of insurers and pension funds and challenging the sustainability of their commitments and business models. The search for yield is a natural but not risk free reaction. Insurance companies and pension funds are thereby investing beyond traditional asset classes and increasing the diversification of their holdings. This could have a positive effect, but could also increase the risk profile of their investments. For this reason, insurance companies and pension funds should avoid exceeding their individual capacity to bear risk. Nowadays more than ever risk management is a crucial and essential tool.”
The call for risk management should apply to both sides of reinsurers businesses, with a disciplined approach to both underwriting and investment becoming increasingly important as the pressure on both sides of their books continues.