Reinsurer cat exposure up, retro flat, says S&P. Capital dynamics evolving?

Some global reinsurance players have been increasing their exposure to catastrophe risks, taking advantage of higher premium rates available, but there hasn’t been a noticeable uptick in retrocession buying as a result, according to S&P Global Ratings.

Reinsurance firms have in some cases “chosen to stop retrenching” leading to a divergence in strategies among them, with the majority of the top-20 reinsurers choosing to increase their catastrophe exposure relative to capital, to benefit from the slightly improved market conditions.

While a few reinsurers have chosen to continue to shrink their exposures, likely due to not feeling rate improvements were sufficient yet.

The major reinsurers have all been steadily expanding their books in the United States for more than a year now, prior to the increases in rates seen, which we’ve been documenting through the big four European reinsurers results each quarter.

Now, on the back of an improved reinsurance pricing environment, others are following suit, taking the opportunity to expand at a time when the insurance-linked securities (ILS) market had been somewhat dented by catastrophe losses, leaving it with a little less capacity at recent renewals and providing opportunity for some traditional players.

On average, after the renewals, S&P Global Ratings says that reinsurers’ property catastrophe risk appetite at a 1-in-250-year return period increased to reach 29% of shareholder equity, although some reinsurers saw reductions of more than 5 percentage points at the same time.

While alternative capital growth in reinsurance has paused to a degree, while the hangover of prior year losses is dealt with, there hasn’t as yet been a noticeable shift in reinsurers retrocession strategies, S&P explains, suggesting that with more catastrophe risk taken onboard, they in the main now carry greater exposure than before.

While S&P says that it expects risk discipline to remain, it does also caution that “global reinsurers’ greater exposure to catastrophe risk could heighten their earnings and capital volatility,” going forwards.

This has ramifications for those third-party capital partners, both in terms of opportunity, as there may be more chances to share in the risks underwritten by reinsurers, particularly if they lack other sources of retro, but also as the peak PML’s of reinsurers portfolios may now be higher than before, which investors in third-party capital vehicles will need to ensure they are being adequately compensated for carrying.

“Earnings volatility could be higher than historically observed, where exposure has increased,” S&P warns.

But, continuing strong capital adequacy provides reinsurers with a cushion again catastrophe risks still, with the traditional side of the industry still very well capitalised.

At the same time, joint-venture and third-party capital vehicles are also a buffer for reinsurance firms, which have in some cases enabled them to underwrite more catastrophe risk at the recent renewals.

Given the increased catastrophe risk exposure, S&P believes that a major industry loss could cause more rating downgrades across the reinsurance sector now.

“If a 1-in-100-year event hits, causing losses well in excess of $200 billion across the insurance industry, we expect only 12 of the 20 global reinsurers would maintain their current S&P Global Ratings capital adequacy level, as measured by our model,” the rating agency explained.

Despite this increasing catastrophe exposure, particularly among the larger reinsurance firms, the use of retrocession remains relatively flat, S&P notes.

In part, the evaporation of pillared retro capacity and the impacts to the ILS market and alternative capital may go some way to explaining this.

S&P says that “We now see less arbitrage opportunity in buying retrocession than two or three years ago. ”

The arbitrage of retro markets by major reinsurers had been one lever that had helped them to keep growing in a soft market, but with retro capacity drying up a little this habit seems to have slowed significantly.

Reinsurers had been using alternative capital as a tool, as it “offered a good spread against the inward exposure,” S&P explains.

This means that further rate hardening may result in global reinsurers gradually ceding less of their exposure in the future, the rating agency believes.

In part this is all down to the health of the retro market as well, which thanks to arbitrage and steep price falls had proven relatively dysfunctional at best in recent years.

Is it more healthy now? Possibly. But the rumours of new retro start-ups continue and the retro market may come back into focus towards year-end it seems.

Overall, S&P believes that reinsurers buffers against catastrophes remain sufficient.

It would be interesting to understand how much of those buffers are due to third-party capital these days, given the expansion of quota shares to the capital markets, as well as sidecars and other ILS style vehicles operated by the leading reinsurers.

Even a 1-in-10 year catastrophe loss would surpass the catastrophe budget for the sector, S&P believes, while a 1-in-50 year event would hit reinsurers capital, exceeding the cat budget and annual earnings.

But, profits can still absorb a $150 billion catastrophe industry loss year, S&P says, showing that it remains well-capitalised even under higher exposure and lower retro protection levels.

The rating agency warns though that if market hardening in reinsurance continues, the temptation to expand may as well.

Leading S&P to conclude, “Although indications that reinsurers are relaxing their underwriting discipline remain weak, reinsurers will face difficult strategic decisions if the cycle starts to turn. Overexposure risks their balance sheet and earnings, but underexposure will cause them to miss out on the higher returns that the property catastrophe space might offer. Reinsurers will need to find the right balance.”

Adding more catastrophe risk while buying less retrocession is not in itself a problem, if portfolio and risk management is strong and guidelines adhered to. But it’s when reinsurers get greedy to fill up on higher rates that problems could begin to manifest.

We believe that the use of third-party capital in internal managed vehicles is only going to increase in the current market conditions, placing alternative capital and the ILS market at the core of reinsurers risk management strategies.

In the long-term that means increased ILS capital within the reinsurance sector in general.

Which also means we’ll see reinsurers that are increasingly reliant on fee income earned from these ventures. While facing the challenge of demonstrating that fee income earned can really replace the income that holding risks on their own balance-sheet generates.

Growing while using another’s capital may generate less income than using your own, which to us implies a continued and accelerating need for efficiency and lower expenses in the reinsurance sector, as the reinsurer capital base continues to adjust to suit evolving market dynamics.