The global reinsurance market shows signs that the pressure on pricing due to soft market conditions is slowing, as rate declines decelerated at the mid-year renewals, but reinsurers, despite remaining profitable, are still under pressure, according to Fitch.
Reinsurance market pricing “could be approaching a new equilibrium” according to Fitch Ratings in a just released sector report. After consecutive quarters of pressure over recent years, the rating agency has joined the widely held view that a floor is emerging, at least in some areas of the market.
Despite the signs that a floor could emerge on pricing in reinsurance, Fitch remains negative on the fundamental outlook for the sector and warns that, while still profitable, there are negative pressures on reinsurers which are apparent in their recent underwriting results.
Reinsurance pricing has been pressured by inflows of new money from investors ranging from private equity, to pension funds, hedge funds and other investors in insurance-linked securities (ILS).
Fitch notes that the flow of alternative capital into reinsurance is slowing slightly, particularly from collateralized reinsurance. Fitch also notes that ILS pricing has stabilised, with a spread of around 100bps between the returns of ILS and high-yield bonds. Fitch says that it believes that “capital market investors may have a waning appetite for reinsurance risk.”
This is interesting. At the recent mid-year renewals there was perhaps more reinsurance capacity underwritten on a collateralized basis by ILS funds and investors than ever before. There is also little in the way of evidence that investors are reducing their appetite for the reinsurance and ILS sector. However, there is ample evidence that investors and managers are now being more cautious about throwing capacity into the ring, unless they have the opportunities to deploy it, so perhaps this is what Fitch has seen.
That is something that needs to play out over time. ILS fund managers as a market command more capital than ever before, as a portion of the global reinsurance market. Should that figure begin to wane then perhaps it can be said that investors have a waning appetite for reinsurance risk.
Perhaps it would be more accurate to say that investors and managers have a waning appetite for reinsurance risk at the very low pricing levels seen recently. Hence the attempts to establish a floor. In fact Fitch clarifies this in its report, saying; “capital market investors may have a lower future appetite for reinsurance risk.”
Fitch notes that, aside from the pressure created by a market that is awash with traditional and growing alternative capital, “premium declines and some upward pressure on ceding commissions helped to drive negative growth in first-half 2015 profits.”
A number of non-catastrophe marine events, such as the Pemex offshore rig explosion, have contributed to a decline in underwriting profits at reinsurers at the end of the first-half, Fitch notes.
Fitch notes a deterioration in underwriting returns due to “a reduction in excess of loss property catastrophe business written by traditional reinsurers and an increase in casualty reinsurance.”
Fitch also notes a shift towards quota share business, as excess of loss pricing hit the floor. Fitch explains why this can affect reinsurer results; “Quota share reinsurance business carries a higher, but less volatile, average loss ratio than excess of loss and property catastrophe business.”
As a result of the continued soft market conditions, which even if a floor in pricing is established do not look set to ease, reinsurance company consolidation through mergers and acquisitions is set to continue,. Fitch predicts.
Interestingly, Fitch is taking a stronger and more negative on M&A now, warning that M&A for the sake of scale and diversification may not be looked on favourably.
“While some consolidation might be a slight credit positive for moderating competitive pressures, Fitch is likely to negatively view deals where achieving greater scale and diversity is the singular purpose of the deal and strategic rationales are unconvincing,” the rating agency explains.
Many of the M&A deals we’ve seen could largely be considered as attempts to acquire scale and diversity. It will be interesting to see how the rating agencies look on the combined companies if they don’t quickly start to show the benefits that they had forecast.
Fitch looks positively on the fact that major catastrophe losses continue to remain low and that prior year reserve development remains positive, helping to boost returns at reinsurers. Of course these factors could turn the other way very quickly in a poor catastrophe year, or if reserving has not been as prudent as required in an environment like this.
On the deceleration in pricing, Fitch explains that the new demand seen in the Florida property catastrophe market, from primary insurers and the Florida Hurricane Catastrophe Fund, have supported demand levels. “This factor drove the deceleration on rate declines in our view,” Fitch explains.
Fitch notes a slight deterioration in capital levels at reinsurers, due to investment losses on fixed income portfolios, continued returns of capital to shareholders and also the cost of pursuing M&A transactions.
Combined ratios across the 22 reinsurers that Fitch tracks rose to 89.3% in the first-half of 2015, compared to 88.3% a year earlier. Fitch also notes a slowing in reserve releases, which as we’ve said before is something to watch, particularly if loss costs jumped dramatically and reserve releases are no longer able to bring the combined ratios back down to manageable levels.
Encouragingly, Fitch says that it has also noted a slow down in the expansion of terms and conditions, as reinsurers have begun to say no to further stretching of the terms of underwriting.
Fitch explains; “Terms and conditions may have reached an inflection point, with ceding commissions stabilising and multi-year deals being offered less often.”
Non-life reinsurers are, in this environment, struggling for premium growth, Fitch notes. This is one of the reasons for the shift into casualty risks, or the search for diversification into primary business lines.
Muted net premium growth across non-life reinsurers is a result of :”Flat or declining prices in both property and casualty reinsurance lines, reduced overall reinsurance demand and opportunistic retrocessional reinsurance purchases,” Fitch said.
The shift into specialty lines of reinsurance business and expansion in this area of the market was offset slightly by continued pressure on property catastrophe lines, Fitch explained, as prices continued to drop and competition from alternative markets remained high.
Despite all the pressures there are signs of moderation, according to Fitch, as both pricing and terms begin to be managed and the appetite for underwriting or investing in risk at ever lower returns evaporates. That’s healthy for the market, shows the establishment of a floor, but also brings into question the efficiency of capital, we believe.
Even at a floor established at current pricing levels, how long can traditional reinsurers continue to assume risk at those levels of return? Fitch warns that the market is not set to get any easier for the traditional players business model.
“Fitch believes that it will become increasingly difficult for the segment to generate adequate returns on capital due to the lack of a catalyst for a reversal in the softening rate environment,” the rating agency cautions.
This is a key statement from Fitch. While reinsurer results have remained adequate, there is a growing opinion among reinsurance market observers that it is going to be hard for reinsurers to maintain adequate returns on the capital deployed going forwards.
This raises a few questions on just how deep the structural change we’ve seen in reinsurance has really gone.
When major catastrophe losses occur, will reinsurers be able to hike pricing and rates to the levels seen historically, or will ILS and alternative capital investors moderate any future rate hikes?
Will the insurance – reinsurance value chain continue to get disrupted, as the capital markets seeks to remove intermediation, get closer to the ultimate source of the risk and at the same time brokers increasingly look to marshal capital themselves?
Will the recent expansion of terms and conditions, which have effectively resulted in reinsurers taking on increasing amounts of risk, at ever lower returns, come back to bite?
There is considerable uncertainty in how the reinsurance sector will perform going forwards, as Fitch highlights in its report today.
In the reinsurance market’s favour is the high levels of expertise, the desire to expand into new regions and classes of risk, the massive opportunity to narrow the protection gap and the opportunity to leverage data and technology to make the whole business model more efficient.
In order to break out of the soft market cycle of depression, reinsurers may need to be ready to adapt, embrace new capital, learn to disrupt themselves, as well as their competitors and those up or down the food chain.
It’s still a challenging market but the opportunities to progress, even under a soft market cycle, are becoming clearer all the time. But while companies continue to drive rates down in a search for underwriting return the pressures are set to remain.
The “lack of a catalyst for a reversal in the softening rate environment” is a key warning from Fitch. Until that catalyst appears the pressure will remain and even if one does appear there is no guarantee that the post-soft (hard?) reinsurance market will be anything like the ones we have seen before.