Reinsurance sector no longer earning its cost of equity: Bernstein

The reinsurance sector in 2016 has now seen pricing fall so far that it is no longer earning its cost of equity, according to analysts from Bernstein. But at the same time, the analysts believe further softening is ahead, as “Earnings are not yet painful enough.”

The January 2016 reinsurance renewals saw pricing fall faster than perhaps expected, in some lines of business, particularly specialty risks and casualty, while what was the core softener, U.S. property catastrophe reinsurance, saw rates hold up perhaps better than expected.

However the overall effect on the reinsurance sector, over the last few years of a softening market, is that the return on equity of the market has declined steeply and analysts at Bernstein led by Thomas Seidl and Josh Stirling, believe that it has now tumbled so far that earning sufficient underwriting returns to cover reinsurers cost-of-capital is at risk.

The analysts ask the question that is on many reinsurance executives lips, where is the bottom of this soft market?

In recent years, the analysts note, earnings have been “flattered” by low levels of catastrophe losses and other one-offs. That means to really assess the sector you need to look at normalised earnings and returns on equity (ROE’s), which is how reinsurers price and budget Bernstein notes.

Bernstein’s analysts estimate that the decline in average normalised return on equity of reinsurers has dropped, from Swiss Re’s sigma reported 6-7% in 2015, down to just 5% for 2016.

At an adjusted return on equity of 5% the analysts explain that “the sector is not earning its CoE (cost-of-equity) anymore.”

If you’re not covering your cost-of-capital, as the analysts suggest, then as soon as losses return to more normal levels, reserves see any adverse deterioration, or any other factors hit results, things could look negative very quickly for some reinsurance players.

The analysts ask; “Is this already sufficient to make the market turn harder?”

Bernstein is not convinced. While reinsurers said that at the 6% to 7% return level they still saw margins in the business they were underwriting, down at the 5% ROE level Bernstein is not so sure that there is very much margin left to be found.

“We think reinsurers are still willing to go for 1-2 more rounds of softening,” the analysts continue, suggesting that reinsurance has further to soften. “Importantly, this further softening will mainly play increasingly in Non-Cat lines and hence for Cat focused players there is a silver lining on the horizon.”

That is not great news for the market, if true, as more rounds of softening would suggest continued price pressure at the key mid-year June and July renewals in 2016, but also the potential for another, albeit likely smaller, round of softening of prices in January 2017.

If indeed reinsurers are operating at levels where they are not covering their costs of equity and capital already, any further reduction in the ROE below 5% would suggest decreasing profitability is ahead.

“Earnings are not yet painful enough we suggest,” the analysts wrote in their note this morning.

The reduced returns on equity and softened pricing following 1/1, will have the following impact on reinsurers, Bernstein’s analysts explain; “Considering the mix of non-proportional rate changes and increase in commissions we expect the total impact of softer reinsurance pricing to remain unchanged at 2-3%. Hence, underlying loss ratios should increase by 2-3 ppt in 2016/7.”

One brighter area of the reinsurance market, note the analysts, is the U.S. property catastrophe space, where price declines were much lower than in other regions and lines of business at the January renewal.

“The moderation makes us cautiously optimistic that this segment is approaching equilibrium. And indeed, the inflow of new capital has almost stopped for now (and has 50% share in this high margin segment),” the analysts state.

That is indeed a positive, perhaps most positive for the alternative capital and insurance-linked securities (ILS) players who are increasingly taking market share of this key segment of the market.

But for traditional reinsurers, for whom margins on this business may be getting closer to cost-of-capital levels, and with diversifying regions and risks likely paying returns well below cost-of-capital, there currently doesn’t seem much to be bright about unless you have the diversity and scale to reach into primary lines and to innovate on new risks.

Of course, the news that analysts believe that the reinsurance sector is no longer earning its cost-of-capital, brings to mind certain questions and issues.

Such as, how long could this be sustained if we do not see any major catastrophic losses?

What is the true level of risk to the business that reinsurers have been assuming, by underwriting at such low return levels while also expanding terms and taking on more exposure?

Just how efficient does the reinsurance business model need to become, in order to sustain what look to be permanently lower returns?

By that last question, we don’t mean that the 5% ROE’s are necessarily permanent, but if ROE’s never get back to the levels enjoyed in the past and the cycle does not see a huge ‘payback’ bounce in pricing after the next major events, and if certain reinsurers face outsized losses due to increased exposure assumed, how can the traditional business model recover?

Once again, more questions than answers at this stage, but the fall-out after the January renewals just keeps on getting more thought-provoking.

Read all our reinsurance renewals news and analysis here.