Recent catastrophe losses could be a “dreaded scenario” for reinsurers, as they are significant enough to create a drag on earnings, but the losses are not expected to be significant enough to “meaningfully change market dynamics and pricing for a sustained period of time,” A.M. Best says.
This is a worst case scenario for some companies, as the chances of the significant price rises they want and in some cases require to replace lost capital seem slim.
A.M. Best estimates that some reinsurers have received as much as a 15% hit to their equity and that it could take most companies around 5 quarters of business to earn back their losses. More realistically, this could take 2 or 3 years before some reinsurers return to the capital base they had prior to the losses, even factoring in whatever price rises we see which could speed this process of recovery somewhat, rating agency A.M. Best believes.
Hence A.M. Best says that reinsurance firms face a “dreaded scenario” where they are seriously impaired by losses but the market doesn’t respond sufficiently to enable them to earn back the losses as quickly as they want.
The hurricanes and earthquakes, plus California wildfires, could cause a $100 billion or so hit to the insurance and reinsurance industry, but this may not be sufficient to create the pressure required to lift rates considerably.
While many are calling for significant rate increases, the broader expectation is that it will be largely focused on loss affected areas, or where pricing had fallen too low.
The size of price increases is also expected to be insufficient to assist reinsurers in recovering more rapidly it seems.
What’s clear is that the appetite of capital market investors and the ability of the ILS sector to recover, raise new funds and trade forwards, will have a bearing on the amount of rate increases we see at the coming renewals.
“In some respects this is a dreaded scenario, where losses are significant to drag earnings but not significant to meaningfully change market dynamics and pricing for a sustained period of time,” A.M. Best explained, adding “What’s different with these particular hurricane events, however, is the material participation by alternative capital and the unique features of that capacity. The response from this capacity will have a definite effect on the dynamics of the market both near and long term.”
A.M. Best expects that reinsurers will face a 110% combined ratio year in 2017, resulting in returns on equity across the composite of reinsurance firms the rating agency tracks from 0% to -5%.
Earning back the lost opportunity may just not be possible in the current climate and perhaps reinsurers instead need to think about how they price, going forwards, to allow for loss hit years such as this, so pricing adequately across the cycle, instead of discounting when losses are low and competition high, then ramping up rates after losses strike.
If you can earn enough in the loss-free years to cover your losses from the loss-hit years, wouldn’t the overall earnings flow be more sustainable?
Of course, this means reinsurers should price for what they need to be able to afford to have losses, suggesting that in some areas of the market where catastrophe risk has become more commoditised and risks no longer fit their capital, it may not be their capacity that is best put to work.
Using alternative capital to underwrite in markets where the rates just don’t pay you to have losses on your own balance-sheet may be the only way forwards, if reinsurers are to get out of the cycle of peak and trough, and stop demanding the levels of payback that they were able to command in past decades.
That or handing over certain areas of the market to the ILS specialists, by using significant volumes of capital markets backed retrocession to support their ability to underwrite sustainable at the ‘new normal’ level of rates.
Alternative capital has played, “a meaningful role in mitigating the net loss impact from this series of extreme events,” A.M. Best says.
Perhaps alternative capital and ILS can play a meaningful role in helping reinsurers to better manage the cycle of loss-free to loss-hit years, without having to push for such huge payback-linked price hikes in future.
Join us in New York in February 2018 for our next ILS conference