Alongside the growth of ILS, alternative capital, the catastrophe bond and other capital market backed reinsurance capacity, the other main threat to the traditional reinsurance business model in recent years has been the steady decline in investment returns.
In a new report, rating agency Standard & Poor’s notes that it has observed a 30% decline in average net investment yields over the last four years, across the group of 24 global reinsurance firms that it tracks.
Historically, reinsurers have used investment yields as a tool or counterweight, to help them manage or maintain their targeted return on equity. When underwriting results were bad, the investment return at least provided some ability to balance the return books a little more than it does today.
S&P calls the decline in investment yields “collateral damage from accommodative central bank monetary policy since the global financial crisis.”
Central bank policy, quantitative easing and other macroeconomic factors have changed, or perhaps distorted, many asset yields and made achieving the returns that reinsurers enjoyed historically, through investments in assets considered safe, much more challenging to achieve now.
For reinsurance firms this means a need to generate more return, something that reinsurers are now seeing a requirement for on both sides of their business (the asset and liability sides).
S&P explains that reinsurers are “more dependent than ever on generating profits from their insurance underwriting to deliver their targeted return on equity.”
And this at a time when reinsurance pricing has been depressed by soft market conditions and high levels of competition, from both traditional and alternative or ILS players.
While at the same time reinsurers, who are trying to generate profit to replace lost yield, are also taking on more risk than before (per unit underwritten) due to the well-documented expansion of terms and conditions, as well as the shift into longer-tailed lines of business.
It’s easy to see why the traditional business model is under so much pressure, with contributions to return on equity down on the underwriting as well as investment side and reserve releases beginning to wane. It’s no surprise that expense efficiency, cost-of-capital and mergers and acquisitions are topics of conversation right now.
S&P explains that the combination of ultra-low interest rates and compressed credit spreads are reducing the possible returns that insurers and reinsurers can make from their fixed-income portfolios. As a result reinsurers are adjusting their strategies, as they attempt to halt the decline in yields and raise investment income.
Reinsurers are looking at increasing their credit or liquidity risk, lengthening the duration of their assets, or increasing their allocations to risk assets such as equities. But these changes do not come without their own risks, S&P warns.
“This search for yield, however, comes at the expense of deploying greater amounts of risk capital to mitigate potential volatility in asset values,” the rating agency explains.
S&P says that while it has seen an increase in reinsurers’ exposure to equities over the last year or so, it has been a moderate shift and kept within risk tolerances, the rating agency believes. Credit risk exposure has remained relatively stable, but S&P says that some subgroups have added a little more credit risk. Generally, reinsurers’ bond portfolios average ratings remained at ‘AA-‘.
There has been an increase in higher risk assets with reinsurers’ portfolios, S&P says, however it remains moderate at the moment.
Given the strong capital position in which global reinsurance firms generally find themselves, S&P believes that the companies it rates can meet any additional capital requirements that arise due to taking on greater exposure to risk assets.
S&P notes; “Most reinsurers generally have a robust investment framework with close matching of assets and liabilities, particularly for the core/strategic portfolio of assets backing their insurance liabilities.”
This is central to the traditional reinsurance business model, the matching of duration and risk on each side of the business. But with reinsurers beginning to take on more asset risk, at a time when the risk on the underwriting side has no doubt risen, due to expansion of terms, while the return has dropped, could perhaps leave a greater chance that mismatches may occur.
Once again, it has to be said that while the reinsurance market remains under pressure and companies are trying out new strategies on both sides of the balance sheet involving additional risk, the risk management skills of the global reinsurers are going to increasingly be put to the test.
S&P’s report discusses the fact that reinsurers have generally refrained from increasing the duration of their portfolios lately, due to an expectation that interest rate rises were likely in the UK and U.S.
However, with the very recent situation in the Chinese stock market making many economists wonder just how far away the first interest rate rises may be, perhaps reinsurers will be tempted to increase durations just a little now.
On durations of investments, S&P found:
The average duration for the reinsurance peer group remained stable at about 3.1 years in 2014 from 2013. This compares with about 3.6 years for the average duration of liabilities, with a wide range from about 2.0 for short-term property catastrophe-focused companies to 5-plus for reinsurers with longer-tail casualty exposure.
On liquidity risk, the rating agency noted:
We’re also seeing that reinsurers have limited appetite for taking on significant liquidity risk. That’s because of the shorter duration and less predictable nature of their liabilities relative to primary life insurers, particularly for reinsurers exposed to material catastrophe risk. Reinsurers have kept the proportion of real estate assets in their portfolios at less than 5%.
Specifically, on the growing addition of risk assets and equities, S&P explains that equity holdings in reinsurers’ portfolios have grown to 10% in 2014, compared to 7% in 2013. S&P says that this indicates “a material increase in market risk exposure, albeit from a modest base.”
Again, thinking about the Chinese stock market and the knock-on effects on global markets, the increased weighting towards equities does add a new dimension to reinsurance firms as an investment, raising the correlation with wider financial markets.
S&P notes that the hedge fund reinsurer model; “While targeting higher investment returns, it also typically results in higher volatility and a higher risk of material investment losses.”
As the traditional reinsurance business model seeks to add more juice on the asset side, to offset declining investment and underwriting returns, there is a chance that volatility of these companies could increase a little. However S&P maintains that the shift towards riskier assets remains within risk tolerances and so far does not seem too concerned.
S&P stresses the importance that reinsurers focus on maintaining capital strength, while adding risk to investment portfolios. With the macroeconomic environment challenging and uncertain, while at the same time the underwriting environment remains depressed and achieving target returns more difficult, capital strength is perhaps saving reinsurers from greater shareholder scrutiny right now.
The adjustment in investment strategies at the world’s reinsurance firms is another sign of the structural change that the market has undergone in recent years.
With competition set to remain high, capital levels abundant, risk rising on both the underwriting and asset side, while ROE’s remain supported by low catastrophe losses and positive reserves, the line being walked by reinsurers seems to be increasingly narrow.
Here’s the thing. If investment returns are down 30%, with underwriting returns down at least that much across the typical diversified reinsurance book, reserve releases waning and contributing less, while risk is increasing as terms expand and reinsurers look to longer-tailed lines, the requirement for discipline is growing all the time.
If there is one thing to be said for the fully-collateralised reinsurance business model of the ILS and capital market set, it’s that the absence of the asset side of the strategy makes the business much more streamlined and efficient to manage. As a result, perhaps it’s no surprise that for peak short-tailed property catastrophe risks the collateralized reinsurance business model is increasing its hold.