Analysts at Bernstein have warned against the dangers of “bad business” and “underpriced risk” in the reinsurance sector, while reminding market players that in order for the softening environment to turn, “first there must be blood.”
The global reinsurance market has continued its softening trend during the opening weeks of 2016, with rate reductions occurring across the majority of business classes, and reportedly down by roughly 5% to 10% in the property catastrophe arena.
Despite this, an ongoing benign catastrophe loss environment has seen some firms report profitability and growth during difficult market conditions, with some reinsurers confident of earning attractive returns “when the market turns,” says Bernstein.
“We think it is worth remembering that the reinsurance cycle has historically only turned after there has been significant capital impairment. The cycle doesn’t turn until there is blood in the streets,” says Bernstein.
Ample capacity from both traditional and alternative capital sources, coupled with a lack of losses created an extremely competitive reinsurance market landscape in 2015, which resulted in a wave of sector consolidation as companies searched for efficiency, scale, and relevance.
And now, with the pressures and challenges of last year persisting into 2016, the desire to remain relevant to clients and the overall market remains.
Despite reinsurers stressing the importance of disciplined underwriting in a soft market, “all that bad business and underpriced risk is going somewhere in the system. Someone will pay the price when the music stops,” says Bernstein.
It’s certainly an interesting and valid point. With everyone in the sector writing business so cheaply, enabled by the stiff competition and current supply/demand imbalance occupying the space, when cat losses and earnings are returned to more normalised levels, there will likely be some fall-out.
“Even if pricing levels off at these levels, we think it is likely that many are not earning their cost of capital based on any reasonable “normalized” measure of earnings,” said Bernstein.
And those companies that perhaps weren’t quite as disciplined as believed, whether on terms and conditions or accepting underpriced risks or exposures that aren’t properly understood in order to gain an edge on competitors during the softening market, could end up with exposures too high and losses too large to positively withstand the impacts.
That being said, bad business isn’t necessarily bad business for everyone, and some firms, notably the more disciplined, diversified, and larger players might well be able to sustain lower pricing and a lower cost-of-capital for longer than others. The winners and losers will likely be revealed once a large, significant market events takes place.
So effectively it depends if the business meets your cost-of-capital requirements, being disciplined enough to know when to pullback on unprofitable business and adjusting the mix of business accordingly, including the utilisation of alternative reinsurance capacity, which some reinsurers have embraced and used to their benefit.
Furthermore, Bernstein explains, as underlined by numerous industry experts and analysts previously, “the reinsurance industry cycle has secularly changed due to lower barriers to entry for new capital, and though there will always be some cyclicality to this capacity driven business, we do not think companies betting on offsetting soft market losses with hard market gains will fare well.”