With the new year under way and the markets looking busy in the insurance-linked securities, catastrophe bond and reinsurance convergence sectors, we have been speaking to some of the leading participants in the market to get their opinions on how these sectors will evolve in 2012. In this first prediction interview we spoke with Standard & Poor’s Dennis Sugrue, Associate Director, and reinsurance sector lead for EMEA, to get a rating agency view on the markets prospects for 2012.
His response follows below.
Standard & Poor’s is maintaining its stable outlook on the reinsurance sector in spite of the near-record level of catastrophe losses in 2011. Many of the factors that help to form our view remain the same as last year. We believe that surplus capital still exists for the sector, albeit diminished from its peak a year ago; we continue to believe that reinsurers’ ERM capabilities are high, leading the industry, and have helped to keep insurance and investment losses within risk tolerances for the most part; and investment portfolios for the industry in general are typically focused on high-quality, short-duration, liquid assets, which, we believe, have helped to limit the sector’s exposure to the ongoing sovereign debt concerns.
However, we believe the industry as a whole has seen insufficient rate increases to declare that we are in a hard market; investment returns remain low due to persistent low interest rates and macro-economic uncertainty; and we believe the reserve releases that have supported the sector’s earnings in recent years to be unsustainable. In our view, these factors highlight the importance of disciplined underwriting for the industry going forward, but have put returns under further pressure in the near-term. These diminished returns, in conjunction with low interest rates, diminishing reserve margins and the increase in both frequency and severity of cat events could be the drivers behind depressed market valuations compared to historical norms, indicating that investors are currently bearish about the sector.
While the underlying drivers remain familiar, 2011 introduced a number of other factors that will require monitoring, and could impact our view of the sector going forward. The amount of catastrophes, and losses (both economic and insured) that have come out of regions widely viewed to be “diversifying risks” to many global reinsurers has brought the value proposition of these regions into question for many. On the whole, we have not seen capacity removed from these markets, but reinsurers are looking to tighten up terms and demand minimum rate on line. We believe there is also an opportunity for ILS to provide additional solutions for protection here, but the underdeveloped models for these risks pose a hurdle to that industry.
The catastrophe events of 2011 will create a significant drag on the sector’s full-year earnings. While we expect this to be an earnings event for the overall sector, these losses will impact the capital positions of some individual reinsurers. We believe that those reinsurers who have been able to maintain or improve their capital positions during 2011 have a strategic advantage when the pricing environment turns.
Pricing changes in the market have been fragmented, with global property-cat and global marine/energy rates seeing increases of 5-10% across the board, but mixed movements in all other lines. The pricing impact of updates to vendor cat models has been muted relative to the market’s expectations. In some lines, we believe the rate increases seen are not sufficient to cover increasing loss costs or the increased view of risk. We therefore do not believe the market has turned from “soft” to “hard” across the board yet.
The lack of a major spike, or indication of a prolonged rise in the cost of traditional reinsurance supports our view that ILS convergence is not likely in the coming years, and that ILS will remain a complementary product to reinsurance. However, we have noted increased interest in ILS in the second half of 2011, and believe there is a strong pipeline of deals coming to market in the first quarter of 2012. This is likely driven by insurers’ looking for additional capacity during the second half of 2011 following the loss events earlier in the year, or the possibly the benefit of multi-year coverage at a fixed price, especially for aggregate structures. In addition, we note that investor interest in ILS is strong compared to the depressed valuations we are seeing for traditional reinsurance companies who are currently trading below book, and historical averages. We believe that in the wake of a major capital event for the market, ILS solutions such as sidecars, cat bonds, and ILWs will compete with recapitalizations of existing reinsurers, and the formations of new entities, due to their ease of establishment, defined investment period, and prescriptive risk selection.
Going forward, we believe that there will be clear winners and losers that emerge from the current market conditions. While we view capital to be in an excess position for the sector, there is a wide discrepancy amongst companies, with some operating with capital at or below their rating level. We believe that reinsurers with strong capital positions, and with the footprint and strategic risk assessment capabilities strong enough to capitalize on the sectors that are seeing rate increases, while managing the downside in other markets, are the ones who are poised to benefit from developments in the coming year; while others may struggle to defend their positions and profitability.
For the sector as a whole, we continue to anticipate that ratings actions, both up and down, should be evenly weighted in the coming year. However, should the industry fail to generate sufficient profitability and thus maintain its balance sheet strength, or should we see a major shock to industry capital, we could revise the outlook on the sector.
Our thanks go to Dennis for his time and the insight provided by S&P.