A.M. Best is maintaining a negative sector outlook on the global reinsurance industry, citing “significant ongoing market challenges” which it expects will be a “strain on profitability” while the sector also faces ongoing pressure from convergence capital.
Rating agency A.M. Best has had a negative outlook in place on the global reinsurance sector since August 2014, as the factors applying pressure on reinsurers just kept increasing throughout the year leaving all the major rating agencies with little choice but to turn negative on the sectors outlook.
The negative outlook persists, A.M. Best says in an update on its sector outlook, and in fact deserves a longer term view than its typical 12 to 18 months outlook, showing that the rating agency does not see any change coming in the next year or more.
“As compression continues bearing down on investment yields and underwriting margins, this strain on profitability ultimately will place a drag on financial strength,” Robert DeRose, Vice President at A.M. Best explains in the update.
DeRose continues; “At this point, A.M. Best’s view is longer term than the typical 12 to 18 months. While A.M. Best does not anticipate a significant number of negative outlooks or downgrades over the very near term, the market’s struggles at this point present significant longer term challenges for the industry.”
Negative influences on the global reinsurance sector include the continued declines in reinsurance rates, further broadening of terms and conditions, an unsustainable flow of net favourable loss reserve development, low investment yields and the continued pressure applied by alternative reinsurance capital and ILS. All of these contribute to the negative sector outlook and are expected to adversely impact reinsurers risk-adjusted returns over the longer term.
Reinsurance companies have been responding though, with initiatives in third-party capital management or sharing risks with ILS investors increasingly being seen.
“Reinsurers are responding to these challenges by employing greater capital market capacity to help optimize results and reduce net probable maximum losses (PMLs) for peak zones as a percentage of capital,” DeRose explained.
Other efforts to stave off the pressure include active cycle management, including switching capacity from primary to reinsurance lines by those companies capable of this, as well as efforts to create new business opportunities or move into new geographic regions. On the asset side of the balance sheet some reinsurers are moving gradually into new asset classes, or adding a little risk, in an attempt to increase investment yield.
Mergers and acquisition of course get a mention as something expected to increase in frequency, or at least noise due to the challenging reinsurance market environment.
“Further market consolidation is also a likely response to the current market environment as balance sheet scale becomes an even more important attribute to retain and win new clients,” DeRose writes.
Reinsurer balance sheets remain largely well capitalised and capable of withstanding various stress scenarios, A.M. Best says, which reflects the high levels of capital in the sector that reinsurers enjoy thanks to a number of low catastrophe loss years.
However, Best notes that for reinsurers who remain stubbornly focused on stale strategies the risk is that earnings pressure increases, favourable reserve development dry’s up, volatility of earnings increases as a result, and “the ability to earn back losses after events is delayed by the instantaneous inflow of alternative capacity.”
That last point is very interesting as this is the first time we have seen A.M. Best refer explicitly to reinsurers ability to command payback as potentially being under threat before. This is a topic Artemis has covered in-depth, such as in this article ‘Despite capital on sideline, reinsurers expect payback. Should they?‘, as it is clearly less likely that hiking rates significantly post-event is going to be as easy with more (and more-efficient) capital now competing for the risks.
A.M. Best seems to be referring to the likelihood that the reinsurance cycle may never be the same again and reinsurers may not be able to reply on payback, even after the very largest events. There is a growing consensus that rates may never rise quite like they have in the past after major catastrophe or other losses, it seems A.M. Best is joining that view.
A.M. Best says that these issues “reflect increased concern that underwriting discipline, which until recently had been a hallmark of the reinsurance sector, is beginning to diminish” as under-pressure reinsurers attempt to hold onto their market share despite the pressure on their profitability.
Here is the issue. A.M. Best says that even if loss years remain benign, and the net positive reserves keep flowing and financial markets remain stable, it might still be difficult for a reinsurer to achieve a double-digit return.
A double-digit return may have been considered relatively average a few years ago in the reinsurance space, but even in the most optimal market conditions A.M. Best believes being ‘average’ may be more than many reinsurers can hope for.
So efficiency and expense management are going to be increasingly important (once again) in the reinsurance market of 2015. While efficient reinsurance capital, provided by ILS and other direct investment models, has been said to be driving much of the changes we have seen in the reinsurance market in recent years, it seems that for the traditional reinsurance business model being efficient may be exactly what is required.
A.M. Best continues to believe that larger companies with diverse business models, advanced distribution capabilities and broad geographic reach stand the best chance of withstanding the market pressures. These firms are better able to target profitable opportunities when they present themselves. At the same time “dynamic capital management” is required to manage the cycle and remain relevant to equity investors, A.M. Best says.
The negative outlook remains in place and it’s clear that A.M. Best has put additional thought behind it and finds conditions no better, in fact perhaps worse, for traditional reinsurers. It seems clear now that those reinsurers without at least a plan of action stand little chance of performing to a level that may even be considered adequate by their investors. No wonder so many companies are working on new initiatives in this market environment. Moving forwards without a plan for how you will navigate the challenging reinsurance market seems no longer to be an option.