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ILS capital up 7%, while underlying reinsurance RoE’s shrink further: Willis


Insurance-linked securities (ILS) and alternative reinsurance capital continued to grow in 2016, rising from $70 billion by over 7% in the year to reach $75 billion, while at the same time the underlying return-on-equity (RoE) of the reinsurance sector has continued to shrink, according to data from Willis Re.

In the brokers latest study on the reinsurance sector, Willis Re reports that aggregate shareholders’ funds of the companies it tracks had risen by 4% to reach $344.1 billion at the end of 2016.

Adding in alternative capital and a pro-rata share of capital from insurers where reinsurance premiums make up more than 10% of their business, the figure rises to $449 billion, up from $427 billion in the prior year.

The $75 billion of alternative reinsurance capital, that Willis Re saw at 31st December 2016, made up an impressive near 17% of the total reinsurance capital the broker reports, reflecting an increasing share of the market falling to ILS funds and other collateralized reinsurance vehicles.

The effects of growing competition from alternative markets and the softened state of reinsurance pricing are clearly evident in Willis Re’s data.

The aggregate net income for reinsurers tracked by the broker fell to $26.6 billion from $30.3 billion in 2016, which resulted in the overall return on equity (ROE) of the sector dropping to 8.0%, down from 9.3% at the end of 2015.

That’s quite a drop in a single year, especially a year when reinsurance price declines had been seen to be decelerating.

One of the issues facing reinsurers right now is that they seem unable to control their expense ratios, despite the pressure they face and the fact the industry has been aware of the need to increase the efficiency of its underwriting capacity for a number of years now.

In fact, Willis Re reports that the expense ratio negative impact on RoE’s has increased slightly (to 2.5% from 2.4% and that for the subset of companies that it can track full data for the aggregate expense ratio has actually increased by around 4% to 33.2% over the last nine years.

“The challenge of increasing expense bases continues to add further pressure to earnings,” the broker explains.

Even more tellingly, for the subset of reinsurance companies that Willis Re tracks the full data for the underlying return on equity (RoE), so adjusted for reserve releases and a normalised catastrophe loss ratio, dropped to just 3.3% in 2016 from 3.4% in the prior year.

The result is continuing margin erosion, with reinsurers operating close to break-even. As seen in the recent Lloyd’s syndicate results, this is also reflected across specialty insurance markets as well and break-even, or just a plain lack of profitability, appears to be becoming more prevalent in re/insurance results.

Global CEO of Willis Re John Cavanagh explained; “The continued challenging conditions of the market further impacts pressure on margins. However buyers can take comfort from the fact that the market balance sheet and headline figures remain robust in the face of persistent market softening due to continued reasonable net income and measured capital management strategies.”

When the profitability is draining out of the business, as has been seen in reinsurance over the last few years, efficiency, reducing expenses and raising margins are all absolutely key.

Hence the trends we see right now, such as where the major reinsurers are increasingly looking to underwrite primary insurance risks in order to secure higher margins, or reinsurers increasing use of alternative capital to reduce overall cost of underwriting capital, or other companies establishing third-party capital backed self-reinsurance total-return vehicles.

All of the above, and more strategies that are emerging, enable the traditional reinsurer to increase efficiency, reduce the cost of its capital and squeeze more margins out of the premiums it underwrites.

Expense control is an interesting one though, as the strategy seems to be to go in the other direction. As expenses rose in recent years, despite best efforts, there does not seem to have been any truly concerted attempt to pull-back on spend significantly in order to add another percent or two to returns.

While reinsurers invest in digitalisation projects, modernisation and programs and directly into technology start-ups (many of which will fail, as is the way with venture capital) it’s hard to see where the cuts are going to come from in a hurry.

In time spend on this items will of course increase efficiency, as will investment in structures that pull alternative and third-party capital into the underwriting capacity pool, but while returns continue to dwindle it seems reinsurers could do with an RoE boost much more quickly than these benefits are likely to flow through.

Does that raise the chance of reinsurers putting upwards pressure on prices?

Certainly. It would seem natural that traditional reinsurers continue to ease off on price declines, perhaps turning to price increases instead. The question then is whether the alternative and ILS markets will maintain lower pricing in order to keep price efficiency and a lower-cost of capital on their side.

It’s extremely unlikely that reinsurers ever see the price rises in the cycle that were enjoyed even just a decade ago though, as any rises forced through are likely to be focused on specific lines, regions and even specific contract types. Recouping the lost margin just doesn’t seem possible, so efficiency will continue to be key.

The conundrum for reinsurers is that their own capital continues to increase, meaning the pressure to deploy it does too, which exacerbates the pressure on reinsurance rates even further.

With alternative capital increasing at the same time, with that rate of increase having likely risen so far in 2017 as new pricing lows for ILS structures such as catastrophe bonds have been seen, the prospects of lower pressure on the traditional reinsurance business model seem slim.

The need to alter the business model and to embrace efficiency through capital, structures and technology platforms, is clear.

But this isn’t just about revamping the reinsurance business model. It’s about making risk transfer more efficient and the end-result of that could be markets (both traditional reinsurance and ILS) that look very different to the ones we see today.

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