Because of its expected permanence, the growth of alternative, or third-party, reinsurance capital is being considered a credit negative for traditional reinsurers by rating agency Fitch Ratings.
Fitch Ratings says that a “significant portion” of the money sourced from capital market investors, typically managed by dedicated insurance linked investment managers in ILS funds invested in assets such as catastrophe bonds, sidecars, collateralized reinsurance and industry loss warranties (ILW’s), is expected to remain permanent.
With reinsurers challenged by lower pricing, higher levels of competition and facing disruption from new entrants, Fitch says that the growth of ILS and alternative capital in the market is likely to have long-term implications, leading it to view the current soft market as not simply a normal reinsurance market cycle but a sign of structural change.
We wrote some broader thoughts on this yesterday in our article suggesting that the structural change is likely to result in a deeper reinsurance convergence. Fitch says that it expects reinsurance pricing will fall further, as a result of continued competition from alternative capital, with further weakening of terms and conditions also expected across a broader range of business lines in 2015.
Fitch’s outlook for 2015 is pessimistic and suggests a very difficult time for traditional reinsurers as they deal with structural change, this deeper convergence and the continued competition posed by alternative reinsurance capital. However it does expect the majority of reinsurers will maintain adequate profitability and capitalisation despite the softening of pricing.
While most reinsurers are expected to escape rating changes, either down or up, Fitch does foresee a heightened risk that some monoline reinsurers, particularly those focused on property catastrophe business, could be downgraded or moved to a negative rating outlook. At the same time some larger, more resilient reinsurers could be upgraded if they successfully navigate the tricky market conditions to outperform.
Additionally, Fitch warns that the continued low investment yields in the broader financial markets increases the risk of “adverse investor behaviour” as insurers and reinsurers begin to see out higher returns. Adding more risk on the asset side is one response to the erosion of margin on the underwriting side, as reinsurers seek to maintain returns to shareholders.
Fitch notes that hedge fund backed reinsurers are also a strategy that aggravates the soft market, as the use of hedge fund investment strategies can allow a reinsurer to have a pricing advantage, given it aims to outperform the market on the asset side. This results in a lower cost of underwriting capital and is another way that we see new forms of capital exacerbating the soft market right now.
Fitch expects the structural change affecting the reinsurance market, with growing alternative capital and reinsurance buyers changing their habits too, is likely to have long-term implications for the market. It describes the pricing environment that property catastrophe reinsurers face as a “perfect storm”, a term we’ve used ourselves over the last year to describe the pressure created by declining pricing, lower demand and alternative capital in a time of low catastrophe losses in the market.
Fitch says “The prevailing adverse operating environment for reinsurers globally” has a broad reach and extends “beyond what would be considered a normal soft market cycle” and resulting in market conditions that have “created a perfect storm for US property catastrophe reinsurers, with current pricing deterioration in this region viewed as the combination of a cyclical soft market and structural change.”
The U.S. property catastrophe market is ground-zero for the impact of alternative reinsurance capital and ILS. Since peak-zone windstorm activity has reduced in recent years, underwriting capacity has increased as a result and reinsurers are over-capitalised. Add to that the “continued ingress” of alternative capital and it’s easy to see why competition has increased and pricing declined.
Fitch says that the growth of alternative capital “represents a structural change to which reinsurers will be forced to adapt.” The “permanent erosion of profit margins on historically profitable products” is a real possibility, notes Fitch, as alternative capital looks set to smooth the previously peaky reinsurance cycle.
Being adaptable is a key trait in the current reinsurance market. The soft market and increased competition has left nowhere for reinsurers to hide and adapting to the structural change is no longer an option. How reinsurers adapt will be interesting, perhaps telling, as those who fail to adapt may well be on their way to becoming an acquisition target or perhaps even failure.
Fitch says that the pace that softening moves into casualty will be a further critical element of the reinsurance market over the coming months. Traditional reinsurance capital is increasingly diverting in search of better underwriting returns, with casualty and specialty risks both targets. Other startups bringing new forms of capital to casualty, such as Watford Re, will also exacerbate softening across other business lines.
Fitch says that identifying the winners and losers due to the structural change and challenging reinsurance market environment is not easy. The effects of falling premiums and weakened terms and conditions can take years to manifest to the level required to depress a company’s financial strength, Fitch notes. Current results reinforce this view, however it is going to be telling over the next couple of quarters, especially for reinsurers who’s favourable reserve releases begin to dry up.
Fitch views strong market position, strength and diversity as key qualities which can help to contribute to a reinsurers resilience to the challenging market trends. This implies that size matters, but Fitch is careful to note that technical expertise and product specialisms can be just as important and can also offer resilience.
Also read this article from yesterday for much more of our thinking on current reinsurance market trends: Structural change, lower margins, a deeper reinsurance convergence.
Read our other stories on Fitch’s recent reinsurance market reports: