Multi-year reinsurance deals may indicate weaker discipline: S&P

The current trend towards growth of multi-year reinsurance deals, as heightened competition pushes reinsurers to offer coverage enhancements to clients, could indicate a weakening of reinsurance underwriting standards, warns Standard & Poor’s.

In a new report, rating agency S&P explains that reinsurers offering enhancements in order to secure business is a potential sign of lower discipline, a reduction in underwriting standards and their overuse could signal a drop in reinsurers competitive positions.

Increasingly, we are hearing concerns from market participants, on all sides of reinsurance renewals, regarding two factors which are increasingly prevalent in the reinsurance market.

One, is the addition of coverage enhancements, additional features offered in order to secure the business such as bundling in unmodelled risks, adding cyber or terror cover and the offering of multi-year coverage. This trend of expanding the terms and conditions of reinsurance contracts has been prevalent for almost a year now as the market increasingly softened.

The second, is a trend which sees large insurance company cedents buying fewer treaties, bundling coverages into large mega-treaties and consolidating reinsurance buying at the C-Suite level. We’ve spoken to some markets and brokers who have expressed concern about what is really included in these large treaties and whether reinsurance markets have as much visibility or granularity of data allowing them to assess and price these large treaties as effectively as a more segmented buying approach.

Once again these trends have been stimulated by the soft market environment, created by an over-capitalised traditional reinsurance market and the growing size of the alternative capital and insurance-linked securities (ILS) space, along with low levels of catastrophe losses. The resulting competitive and buyers market environment has allowed insurers to get more for their coverage while reinsurers are giving more away.

The report from S&P is the first to directly address this trend, of terms expansion and coverage enhancement, with a warning that it could result in reinsurers (and also ILS managers, investors and funds) accumulating more risk than they expect.

Slack reinsurance demand and soft prices has been forcing reinsurers to go beyond price reductions in order to win business, says S&P, with one incremental offering the multi-year reinsurance deal which has become particularly prevalent in property catastrophe reinsurance renewals.

Due to the fact that multi-year deals proliferate during soft reinsurance market conditions, as underwriters attempt to secure market share, S&P is wary that the trend could indicate a weakening of underwriting standards. While multi-year deals could help reinsurers to defend their market position, if used judiciously, any overuse of such expansion of terms; “Is generally a warning sign that indicates a deteriorating competitive position,” S&P explains.

The provision of more competitive terms and conditions, with the resulting expansion of reinsurance cover offered, is one of the reinsurer responses to growing competition from third-party capital or ILS along with the reduced demand from some large cedents. S&P says it remains skeptical about terms expansion with multi-year offerings, as they tend to be overused in soft market conditions.

S&P has seen this before in the 1990’s, when despite many risks being underpriced and under-reserved reinsurers offered broader terms and multi-year deals. The reality of these decisions was adverse loss reserve development which led many reinsurers to experience financial hardship.

S&P notes that it does not believe that current market conditions are as bad as those seen in the 1990’s, but the momentum towards terms expansion is “undoubtedly negative” which requires reinsurers to redouble efforts to maintain underwriting discipline.

Having a modest proportion of a reinsurance portfolio in multi-year form is to be expected, but ideally S&P would like to see their use limited. “Overuse of multiyear contracts is one factor that could lead to a reassessment of a reinsurer’s competitive position and ultimately a negative rating action,” the rating agency explains.

Multi-year contracts are justified as a way for reinsurers to demonstrate their ability to match the long-relationship they have with cedents with longer term contracts. It’s also a way for reinsurers to demonstrate their ability to match more closely the insurance-linked securities (ILS) catastrophe bond product, which can offer cedents risk transfer over multiple year terms.

However, by offering multi-year reinsurance, reinsurers are preventing themselves from benefiting from any price increases, or rate hikes, as a result of losses or a changing view of risk. They are also putting themselves more at risk to counterparty underwriting standards, as any shift in a cedents underwriting or claims practice may cloud reinsurers insights as to what they are covering in the future.

There can be a mismatch between the term of the insurance contracts and the reinsurance protection, which could influence cedent’s underwriting behaviour. Multi-year reinsurance capacity is typically reserved for cedents with the most stable insurance portfolios and those which are seen as the most secure counterparties, their overuse could result in multi-year cover being offered to cedents who do not have such strong track records.

While multi-year reinsurance contracts can protect reinsurers from further softening and price decreases, it does not automatically mean that they can hike prices as much every few years as they may have been able on an annual renewal basis. This could again lead to a potential mismatch between actual market pricing and the ability to reprice multi-year deals.

Clearly multi-year contracts have benefits for both cedent and reinsurer, but if overused in a softening market environment they could be detrimental to both. If terms are expanded purely to secure premiums, at the expense of discipline, resulting in multi-year reinsurance deals becoming more prevalent we could see adverse development in years to come.

S&P’s report says; “Extending these offerings liberally, especially to cedants with increasingly risky exposures or unstable strategies, may leave reinsurers assuming more risk than they anticipated. Moreover, excessive use would prevent reinsurers from benefiting if reinsurance rates began increasing. What’s more, the inherent hedge against rate decreases could be eliminated if cedants leverage their power in this soft market by pushing reinsurers to prematurely renegotiate terms in their favor.”

The report on multi-year reinsurance deals closes:

“Reinsurers can easily overstep the fine line between judicious use and undisciplined underwriting, so that any growth in multiyear transactions warrants skepticism of reinsurers’ competitive positions.”

There is a considerable risk that reinsurers could be taking on more risk than they expect, as terms and conditions are expanded alongside the bundling of reinsurance buying. The potential for concentration of risk, unexpected losses and adverse development after a loss, increase as terms expand.

While catastrophe losses remain low reinsurers could get away with increasingly giving more away, but when losses return to the market there is a real potential for some players, particularly those who have been more giving than others, to face unexpectedly large or complicated losses.

For some reinsurers, the offering of multi-year protection is not the kind of innovation that is required to successfully navigate the softening market.

Subscribers to S&P services can access the report via this link.