Discipline being shown in the insurance-linked securities (ILS) market, by investors and ILS fund managers, is one of the only factors in the global reinsurance market which is helping to produce the predicted “softening in the softening” of reinsurance rates, according to Willis Re.
Publishing its latest reinsurance renewals report today (sub-titled ‘Pricing Floor Remains Elusive‘), Willis Re, the global reinsurance broking arm of Willis Group, explained that reinsurance pricing continues to deteriorate at pace, with the only slowing in the softening being seen in the key peak peril zones in layers where the ILS market participates the most.
This factor, of ILS investor, ILS fund manager and general ILS market discipline on pricing and terms and conditions, has been cited before as the one thing helping to stem the downward slide in reinsurance pricing at recent renewals.
Once again, Willis Re reports, that the U.S. property catastrophe reinsurance market has seen the biggest slowdown in risk adjusted rate reductions at the key January reinsurance renewal. While the ILS markets have played a major role in driving down peak peril reinsurance pricing, it is now their discipline and ability to say “enough is enough” on price declines which is helping to slow the softening in those markets.
John Cavanagh, Global CEO of Willis Re, explains in the report; “ILS markets have largely taken a more disciplined approach to pricing, given their business models do not allow the same degree of flexibility through diversification as traditional reinsurers.”
As we wrote last week, the traditional reinsurance model that enables companies to reduce rates further by maintaining a diverse book of business has been contributing to further steep declines, particularly as seen in Europe and the UK at the January renewals.
The reports that some European renewals seeing pricing so aggressive and based on the risk model that produced the lowest expected loss is a trend that reflects the ability to lower rates as the risk is a diversifier.
ILS players typically cannot wield the benefits of diversification so strongly when building their portfolios, however they can wield their lower cost-of-capital and efficiency, as witnessed over recent years, but only to the degree where returns can be maintained.
And so this explains the discipline seen among ILS fund managers and investors. ILS players have now neared those pricing levels where returns are close to the minimum acceptable levels for their capital, resulting in a slow down in reinsurance price declines in the peak regions at the risk/return levels where ILS players are most active.
“This trend has underpinned the difference in rate reductions between U.S. property catastrophe excess of loss contracts – particularly on the higher layers – compared to those outside the U.S. where the ILS markets have less penetration,” Cavanagh continued.
However, across the reinsurance market the pricing floor remains elusive, Willis Re’s report explains, with further steep declines in many risks and regions at the 1/1 2016 renewals. As we wrote last week, the price stabilisation hopes have been dashed once again, as reinsurance pricing tumbled across the majority of lines.
Cavanagh explained that the general trend in reinsurance pricing remains down; “Despite signs of price stabilization in peak property catastrophe zones during the June / July 2015 renewals, the hopeful forecasts for a “softening in the softening” at the January 2016 renewal season have proved illusory in all but a few cases.
“Buyers have yet again looked to their reinsurer partners for support in terms of reduced prices and broader coverage to help manage their portfolios as original rates have fallen across most markets and classes.”
The larger reinsurance buyers also continue to rationalise their spend and retain more risk, in some cases, resulting in less premium available for reinsurers to compete for. This continues to make new business development, product development and diversification around the globe, as well as into primary lines, important to enable reinsurers to maintain business levels to put as much of their capacity to work as possible.
Cavanagh also notes in the report that this trend could reflect the fact that “some potentially misplaced optimism around underwriting results also exists as original rates reduce.”
Cavanagh continued; “The January renewals have unfortunately confounded the hopes of commentators that the market was reaching a pricing floor. However, as reinsurers look to close their 2015 accounts, most will likely report reasonable headline results.
“But looks flatter to deceive. As the Willis Reinsurance Index for the first half of 2015 demonstrated, underlying RoEs of reinsurers are at an extremely low 5.1% after adjusting for reserve releases and abnormally low catastrophe losses. 2015’s full year analysis is likely to show further reductions as under-reserving issues start to appear at both a primary company and reinsurer level.”
Willis Re has been quick to analyse this trend over the last year, explaining that the true returns at reinsurance companies are on the wane and expected to wane further, as the impact of price declines and high competition begin to bite.
The result of reducing returns on equity is that, when adjusted for normal loss patterns, some reinsurance classes are exhibiting combined ratios that are approaching 100%, the level where technically they would become unprofitable, or only useful as diversifiers.
On top of declining prices, and reducing underwriting returns, reinsurers and insurers continue to face some of the most challenging investment conditions in years. “The outlook for investment income remains tough,” Cavanagh notes.
The report explains that; “As interest rates rise, some commentators are voicing concern that dislocation in the high yield bond market might be seen as a precursor of further turmoil.”
For the majority of reinsurers, exposure to high yield bonds is not significant and should be manageable, Willis Re’s report explains. However, in any significant market event “there are bound to be outliers” which could suggest that some reinsurers (and likely insurers) have greater exposure to the ongoing investment difficulties and the potential for issues in the high yield bond market.
Mergers & acquisitions (M&A) remain on the table as a possibility for reinsurers, Willis Re says, but “high valuations are increasing the inherent risk in M&A transactions” which Cavanagh explained should “Give potential acquirers without very clear strategic targets and strong nerves even more reason to proceed carefully.”
Against this backdrop of ongoing challenges for reinsurance firms, still declining prices, competitive renewals, further retaining of risk by large clients, difficult investment conditions and continued temptation to use M&A as a lever, Cavanagh cited two positive developments in 2015 which provide an opportunity for the industry.
Cavanagh explained; “First, the recent announcement by Lloyd’s that it plans to launch a trading index to help stimulate the development of a secondary trading market and ‘attract the interest of the wider capital markets’.
“Second, the announcement by Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board, of an industry led task force. Chaired by former New York City Mayor, Michael Bloomberg, it will develop company disclosures for investors to assess physical, liability and transitional risks from climate change and related policies.
“Quantification and disclosure of insurance risk has helped drive reinsurance demand for the last 25 years. These new initiatives are primed to do the same for the global business community: drive demand.”
So there are some bright spots for reinsurers to look forward to and of course those same two bright spots are also key opportunities for the ILS market and its investors.
As reinsurance price declines continue the focus has to turn to how to develop new opportunities to acquire risk. This has been evident in 2015 in the ILS market, as managers and investors have found ways to gain scale, diversity and access risks from new markets and customers.
It’s expected that those trends will continue in 2016, which, if implemented with ongoing discipline by ILS managers and their investors, could result in ILS taking an increasing percentage of some key markets, while traditional reinsurers begin to reach the lower reaches of their ability to cut rates for diversification.
At that point, when ROE’s wane further and diversification benefits are hard to justify, that cost-of-capital and efficiency will once again come to the fore and the ILS market may find itself well positioned to respond positively to any market fall-out.