Another of the major rating agencies who assess the credit quality of the reinsurance sector has changed its outlook to negative today. Moody’s Investors Service now joins Standard & Poor’s and Fitch Ratings in saying that reinsurers face increasing headwinds.
Moody’s has maintained its reinsurance sector outlook at stable for some time, but warned back in April that the downside risks for reinsurers were growing as they approached the key mid-year reinsurance renewal season.
Now, likely after having digested the extent of price softening at the June reinsurance renewals, Moody’s says that it has been prompted to lower its outlook to negative by a number of factors that are pressuring reinsurers simultaneously.
These factors that are converging on reinsurers, making the outlook for the sector look less healthy, are the current oversupply of reinsurance capacity, the growing influence of new entrants in the form of non-traditional and ILS capital, more substitute products, low-interest rates, and greater bargaining power of buyers.
Moody’s expects reinsurers will be pressured by these factors over the next 12 to 18 months, as cheaper alternatives to traditional reinsurance eat into their core business, buyers exert their power and influence and competition between themselves also takes its toll.
Moody’s says that the current soft market bears a strong resemblance to the late 1990’s, with the over-capitalised reinsurance market, double-digit annual price declines, buyers’ wielding increased bargaining power as well as predictions of industry consolidation., however there are some differences.
“One key difference is that reinsurance buyers today have greater incentives to improve capital efficiency, limiting their need for reinsurance,” commented Kevin Lee, Senior Credit Office and author of Moody’s report on the global reinsurance outlook. “Tighter regulatory oversight and the need for better internal governance have pushed insurers to get more mileage out of their capital.”
Increased competition across catastrophe reinsurance products, with the additional influence of billions of investor dollars flowing into reinsurance risks, have resulted in a growing, lower-cost provider of reinsurance protection which is now trying to assert its cost leadership in broader areas of the reinsurance market.
Moody’s says that alternative and ILS capital has already displaced a some of the traditional reinsurers capacity from the catastrophe segment, despite its significance and importance to reinsurers. In order to compete and remain competitive with lower-cost providers, reinsurers are employing a number of defensive strategies, says Moody’s, which it describes as “credit neutral at best.”
Here Moody’s is referring to the relaxation of reinsurance terms and conditions, which it clearly sees as a reaction which may not actually benefit reinsurers in the end and perhaps place some of them at greater risk of negative development.
Moody’s notes that the new lower-cost reinsurance capacity options driven by alternative capital and ILS have taken catastrophe reinsurance pricing down to pre-Katrina levels. With catastrophe reinsurance seen as a subsidising line of business historically by reinsurers, the loss of margin in this area is significant.
Moody’s notes that its outlook could become more pessimistic if pricing drops by another 15% to 20%, which would take reinsurance pricing down to pre-2001 levels. At that low-level reinsurers would struggle to make earn their cost of capital, Moody’s says.
Other factors which could change its view to stable include the exit of some alternative capital as interest rates rise, although Moody’s believes the diversification factor is will continue to attract investors, or a major catastrophe event scaring capital away, although Moody’s would expect a hardening post-catastrophe market to actually attract more capital to reinsurance.
Moody’s notes further threats from alternative capital, including; its ability to move into new lines of business (such as casualty) and impact pricing across a broader swathe of reinsurance, its ability to move into new geographies and pressure reinsurers there and its ability to move downstream and disintermediate reinsurers as well.
Moody’s report focuses in on the lower-cost of ILS and alternative capital, something often forgotten by the mainstream press as has been seen in recent weeks. This is key as it allows investors in reinsurance to embrace the sector to seek debt like yields rather than higher equity investment level returns.
Moody’s asserts that to compete on capacity with ILS, at recent pricing levels, traditional reinsurers would need to; “Lever their exposure at least 3x to 4x (insured limits as a multiple of equity) to meet their cost of equity.”
That is significant and explains why some ILS capital is happy to keep playing at pricing levels where traditional reinsurance players pull back from the market. It should be noted that not all capital wants to be deployed at these low levels and some requires higher returns, but the lower-cost remains and this is hurting many in the reinsurance market.
Moody’s Senior Credit Office Kevin Lee says that the inflow of non-traditional reinsurance capital is helping to accelerate declining prices by:
- Compounding an oversupply of capacity;
- Asserting cost leadership (in certain products) and forcing reinsurers to match its lower prices: ILS funds are trying to lower their cost of capital even further by partnering with fronting insurers to reduce the collateral they need to post, allowing them to leverage their capital;15
- Providing a cheaper source of capital to reinsurers so that they too can lower their costs: Reinsurers are shifting some of their risk to the cat bond or sidecar markets because the cost of protection is cheaper than the cost of holding capital to retain the risk;
- Enabling some reinsurers to use this cheaper capital to maintain or improve position at the expense of weaker competitors: Whereas reinsurers could previously cherry-pick the layers (tranches) they wanted on a specific catastrophe reinsurance program, they are now being forced by buyers and brokers in some cases to participate across multiple layers. This trend is contributing to the emergence of a two-tier market, where the top tier consists of reinsurers that have the capacity to absorb the extra risk and the ability to lay off the unwanted risk cheaply (through the retrocession, cat bond or sidecar markets) and the bottom tier consists of reinsurers that have less flexibility.
Some reinsurers remain better positioned than others, notes Moody’s report, but non are completely immune to the trends ongoing in the reinsurance market. Moody’s focus on reinsurers being able to earn their cost of capital is particularly telling as that suggests that the rating agency will be closely watching expense ratios and combined ratios at reinsurers over the coming months.
“We believe reinsurers that are best positioned to cope with the sector’s challenges are those that have already demonstrated their strategic relevance to clients and possess relevant size, superior claims service, whole-account capabilities, and a solid insurance platform,” said Lee.
With now three major rating agencies all turning negative in terms of a reinsurance sector outlook the clouds continue to gather. There is no clear sign of conditions changing or reinsurers regaining some of their competitiveness in property catastrophe reinsurance meaning that this negative outlook looks set to remain in place for some time to come.