Reinsurance profitability attracts capital, but damages prospects: Fitch

Reinsurance companies are in a vicious circle. With losses remaining low reinsurers report profitable results, which has the effect of attracting more capital, which in turn deteriorates market conditions, but with no serious losses results continue to be attractive to investors.

This vicious circle is creating a negative feedback loop, that is gradually worsening market conditions and putting traditional reinsurance companies under increasing strain.

But they keep reporting relatively attractive results, profits remain high, capital keeps being returned and for many of the newer investors in the space the total return a reinsurer can generate is a very attractive number, despite market conditions.

In a new report Fitch Ratings discusses this vicious circle, saying; “Reinsurers’ profitable results continue to attract capital to the sector, leading to deteriorating reinsurance market conditions and recent accelerated industry consolidation.”

Underwriting results have weakened slightly, due to increased non-catastrophe property losses and higher underlying loss ratios, but larger catastrophe losses remain entirely manageable and favourable loss reserve development persists.

However the slight weakening, resulting in a higher combined ratio in 2014 of 86.4% across reinsurers Fitch Ratings tracks, compared to 85.9% in 2013 is not sufficient to dampen enthusiasm and attraction to the space.

“Reinsurers’ profitable results are promoting product innovation and attracting more capital to the sector from new sources, including private equity firms, hedge funds and pension plans,” Fitch explains in its latest reinsurance sector report.

“This increased supply of capital has created excess underwriting capacity in the reinsurance market, leading to price competition, falling reinsurance rates and the more recent M&A wave,” Fitch continues.

One of the reasons for the higher loss ratios is the shift towards casualty reinsurance business, where you would expect a greater degree of attrition to the combined ratio.

Fitch also explains that; “With pressure on excess of loss premium rates pushing prices down to inadequate levels, reinsurers are shifting into quota share. Quota share reinsurance business carries a higher, but less volatile, average loss ratio than excess of loss and property catastrophe business.”

Premium growth remains limited though, Fitch warns, highlighting that while reinsurers are looking to deploy excess capital reduced demand is making this difficult, alongside the reductions in pricing that can cause reinsurers to pull-back on certain lines or regions.

“Expansion into various specialty lines was partly offset by declines in property catastrophe reinsurance business as prices continue to drop, with increased competition from the growing alternative reinsurance market,” Fitch said.

“This competition includes collateralized reinsurance, sidecar vehicles, industry loss warranties and catastrophe bonds. 2014 experienced a record amount of ILS issuance with USD8.0bn of catastrophe bonds, a level that is likely to be surpassed in 2015,” the rating agency continued.

While reinsurers remain so well capitalised and struggle to put it meaningfully to work in some cases, M&A remains an attractive option. “It is also expected that capital will be used for additional M&A activity,” Fitch explained.

Favourable reserve development is slowing, Fitch warns, which could put more pressure on profitability as reinsurers have been benefiting greatly from conservative reserving practices in prior catastrophe years. With recent years being quieter the reserves are just not as large and so releases are expected to slow.

On M&A, Fitch says that it “maintains a cautious view on M&A due to execution and integration risk, but views a certain amount of sector consolidation positively.”

However the rating agency warns that M&A may not be the panacea some hope for, saying; “Though market consolidation may benefit the newly created, larger, more diversified reinsurers, Fitch believes that it will become increasingly difficult for the segment to generate adequate returns on capital due to the lack of an identifiable catalyst for a reversal in the softening rate environment.”

And the softening that has been witnessed is likely to continue, Fitch explains, highlighting continued inflows of alternative capital into insurance-linked securities (ILS) as a catalyst for ongoing pressure on rates.

“Alternative capital continues to flood the market, including a record amount of insurance-linked securities (ILS) issuance in 2014. This capital abundance leads us to expect a continuation of falling prices and weakening of terms and conditions across a range of reinsurance business lines,” Fitch stated.

With profitability fostering market challenges and consolidation, but with no sign of any losses large enough to rapidly erode profits, the vicious circle may continue for a while longer. There will however come a point where profitability drops to a point where certain business models no longer look so attractive to investors and new sources of capital.

Fitch remains negative on the global reinsurance sector, due to the challenges it faces. The rating agency views market conditions as “unlikely to improve in the near term given the continuing competitive reinsurance market environment.”

However Fitch continues to maintain a stable outlook for the ratings of the reinsurance sector as it says that “most reinsurers will maintain both profitability and balance sheet strength over the next 12-18 months commensurate with current ratings.”

While that’s the case the interest from new capital and as a result the vicious circle will continue.

Of course the answer to the issue of profits attracting capital, thus eroding profits due to competition and pressure on rates, is to find new business, to innovate, to embrace lower-cost sources of capital and to seek to grow opportunities to put capital to work.

If profitability drops sufficiently, due to losses, dwindling reserves, higher combined ratios and softened pricing, and ratings become an issue, it will be interesting to see whether the interest in ILS continues or perhaps grows. As third-party capital seeks out an efficient place to access the returns of reinsurance business.