The challenges faced by traditional reinsurance firms are likely to “extend beyond a normal soft market cycle” as factors such as the growth of alternative capital, changes to the value-chain and higher regulatory costs all weigh on reinsurers, according to Fitch Ratings.
In an update in which the rating agency reiterates its negative outlook for the global reinsurance sector, Fitch implies that this time it is different, with the macro operating factors affecting the traditional business model spreading beyond just the typical soft market cycle effects of lower pricing and higher competition.
Fitch’s observation is correct, the market environment is very different this time, which makes it increasingly difficult to predict how the soft cycle will end and what will happen to the market pricing after the next major loss event.
Fitch repeats its warning that reinsurance prices have not yet found their floor and that further declines in premium prices are expected at renewals to come. Additionally investment yields, while already only making a very small contribution, may shrink further with no sign of any major improvement expected on this side of the balance sheet as well.
Current pricing levels are only just exceeding most reinsurers cost-of-capital, Fitch explains, with further declines in pricing, or any disorderly conduct in the market, likely to result in negative rating actions.
Despite this, and given the benign loss environment, most of the major reinsurers will be able to maintain profitability and capital levels, Fitch explains. However, as the softened cycle persists and factors that make this cycle different accelerate, the risks to reinsurers which struggle to manage change are set to increase.
This time it is different. We’re increasingly looking at a reinsurance market where efficiency, cost-of-capital and the ability to maintain underwriting at lower return hurdles is becoming essential. While at the same time new business models are emerging which seek to extract more of the value from the premiums underwritten, rather than passing them onto reinsurers or service providing intermediaries.
As the desire to extract more value from the business underwritten increases, which is only natural as market participants seek to retain more of their own value-add, we can expect to see even more concerted efforts to break down and disrupt the risk-insurance-reinsurance value-chain.
The emergence of more efficient underwriting capital models, such as the insurance-linked securities (ILS) fund market and collateralised reinsurance, but also the hybrid or total return reinsurance vehicles being launched internally at large re/insurance players, all demonstrate the need for efficiency and to hold onto more of the premium profit generated.
Technology is going to be another key driver towards efficiency, particularly as the financial technology (or Fintech) trend begins to look to insurance and reinsurance as a market ripe for disruption. Once Fintech gets beyond its initial forays into re/insurance (which have been laden with buzzwords), it will begin to target ways to help incumbents become more efficient, as well as establishing entirely new business models that only serve to increase the competition.
So capital, technology and an increasing realisation that efficiency is key, all this combines to make the current soft reinsurance market cycle different this time, which may ramp up and sustain the pressure on those that struggle to adapt.
Fitch highlights a “diverging ability to manage change” among reinsurers. While the large Tier 1 players are mostly well-positioned to even capitalise on market forces and innovation, some players may not be. Any signs of divergence could provide an early sign of winners and losers.
Fitch also highlights that alternative capital will likely increase pricing competition. It is after the next major catastrophe events that this may become most evident, when the traditional players find they cannot ramp prices in the wake of losses as much as they would have liked to, due to inflows of alternative capital.
Of course the forward thinking traditional players will, at that time, also be ramping up their own third-party reinsurance capital vehicles, to ensure that they are able to take advantage of any market dislocation and resulting opportunities as well.
Soft markets happen in reinsurance, many remember the last and will remember this one when the next softening cycle happens. But this time it is increasingly considered to be different, due to factors such as the growth of ILS and alternative capital.
That provides real opportunities for those prepared to embrace change, and as Fitch explained able to manage it well. It also provides an increased threat to those that can’t.
But, if things are different now the market may be shocked by how quickly conditions become radically different over the coming years, as other factors such as the rise of Fintech begin to impinge on traditional reinsurance market business practices.
We talk about value-chain disruption now. But as efficient capital (ILS, capital markets or otherwise) increasingly gets connected directly to risk through efficient technology (in years to come), the wholesale disruption that will be seen has the potential to be quite a shock to any that are unprepared.