Reinsurer returns near cost-of-capital, ILS to win more market share: Moody’s

Reinsurance underwriting returns are expected to near, or even fall below, the sectors cost-of-capital in 2015, according to rating agency Moody’s, while at the same time alternative capital and ILS is expected to win more market share as it asserts cost leadership.

Moody’s Investor Service has published its 2015 outlook for the reinsurance sector, titled ‘Global Reinsurance – Negative Outlook: Buyers Wield Strong Bargaining Power and Continue to Explore Cheaper Alternatives to Traditional Reinsurance.’

The rating agency maintains its negative outlook on the reinsurance sector, as the excess levels of traditional reinsurance capital and continued inflows of alternative capital compete for a pot of reinsurance business which is not growing rapidly enough to satisfy everyone’s underwriting needs.

Moody’s, like all the other insurance rating agencies, has had a negative sector outlook on global reinsurance since June. Also in June Moody’s warned that technical pricing on catastrophe reinsurance renewals could fall below reinsurers technical minimum pricing levels at the 2015 renewals, a message it reiterates in its latest outlook.

“Competition will further squeeze industry returns in 2015-16 to levels near or below the industry’s cost of capital,” commented Kevin Lee, Moody’s Vice President and Senior Credit Officer. “Traditional reinsurers are fighting over a declining number of contracts and at the same time losing market share to cheaper substitute products backed by alternative capital. As a result, we don’t think the market is going to turn anytime soon, barring some kind of large natural disaster or unexpected loss that changes buyers’ and sellers’ perception of risk.”

Artemis has discussed expected pricing levels on January catastrophe reinsurance renewals with some market sources who suggest that many contracts are already approaching the technical pricing levels. There are reports of contracts with pricing significantly lower than the levels seen a year earlier, which will result in more reinsurers pulling back on certain geographies and perils, we’d imagine, as they seek to avoid underwriting business which no longer supports their cost-of-capital.

Moody’s believes that the reinsurance market is set to become even more tiered, with buyers favouring selected reinsurers and alternatives to traditional reinsurance. The marginalisation of smaller reinsurers looks set to continue which can only increase the pressure on smaller to mid-sized players.

This trend is more secular than cyclical, Moody’s explains, the two most important of which are changes in reinsurance buying behaviour and the increasing penetration of cheaper alternatives to traditional covers.

As a result and as this pressure continues to increase, Moody’s expects competition will squeeze the industry’s returns further in 2015 (normalised for catastrophe losses) to a level that is at or below the sector’s cost-of-capital.

With no change in the market’s fortunes expected for 12 to 18 months, unless large losses hit the sector, the outlook remains gloomy for reinsurers. The ones best able to defend their competitive positions will be those reinsurers with scale, geographic and product diversity and those with strong broker and client relationships. That favours the largest of reinsurers but leaves the smaller players perhaps open to consolidation pressures.

Further bad news for reinsurers is that buying behaviour is expected to continue to change. Large insurers have been consolidating treaties and ceding less premium, a trend that Moody’s does not expect to reverse.

Moody’s explains this trend:

At least two secular factors are driving this reduced need for reinsurance: (a) US insurers have been steadily deleveraging since 2002; and (b) the prospect of tighter regulations and wider adoption of capital models have incentivized insurers (buyers) to manage their risks holistically across geographies and products. As a result they get more diversification mileage out of their capital and can bundle their diverse exposures into fewer reinsurance treaties, creating less need for reinsurance overall.

As a result, insurers are tending towards large, globally active reinsurers that can support their needs on large, bundled treaties and more complex products.

Moody’s doesn’t mention the trend towards insurers leveraging retention vehicles, such as the rumoured ACE Blackrock almost self-reinsurance captive vehicle with an active asset strategy. This is a trend that is in its infancy, but one which could ultimately see even lower amounts of premiums ceded into the global reinsurance market.

Compounding the issues created by excess capital, increased competition and decreasing amounts of ceded premium available to compete over, is of course alternative or third-party reinsurance capital and insurance-linked securities.

Alternative capital will attempt to assert its cost-leadership wherever it can, says Moody’s. Reinsurers will continue to lose market share to cheaper ILS and alternative reinsurance products, such as catastrophe bonds, collateralized reinsurance sold by ILS funds and other vehicles such as hedge fund reinsurers.

This reflects the fact that ILS fund managers and investors have come to appreciate that their cost-of-capital is lower than a traditional reinsurer and they have now embraced this low-level of pricing to take market share from their traditional competitors.

Reinsurers defensive strategies against the influence of ILS and alternative capital are credit negative at best, says Moody’s, with many affected reinsurers switching their focus away from catastrophe reinsurance to other lines of business.

Moody’s says that it is concerned that alternative capital will gradually squeeze some reinsurers out completely, but the rating agency notes that ILS products remain incomparable on certain features such as reinstatements. However we would note the trend towards ILS capital working with large traditional players in order to add leverage, provide reinstatements and other features that they cannot offer alone. That may be a trend to watch as ILS capital continues to take market share, the savviest reinsurers may look to work with ILS, rather than against it.

Moody’s expects further declines in reinsurance rates and is working on an assumption of a -10% decline in catastrophe reinsurance rates through 2015 and a mid-to-high single digit price decline in casualty reinsurance rates, so at a slower rate than seen this year. As long as reinsurers can meet their cost-of-capital and continue to share risk with alternative markets Moody’s expects the downward pressure will continue.

However, these rate declines will see reinsurance underwriting returns nearing reinsurers cost-of-capital in 2015, the point at which continued underwriting of business which isn’t returning a profit just doesn’t make sense. Moody’s notes that the pricing pressure on catastrophe reinsurance lines may moderate as alternative capital and ILS has now approached pricing levels where ILS managers and investors do not have much headroom to drive prices down further.

Interestingly Moody’s report does not mention the relaxation and expansion of terms and conditions, something which continues to be cited as being seen in reinsurance renewal contracts. Are reinsurance returns approaching cost-of-capital based on terms as they were a year ago or more, or does this factor in the expansion of coverage as well? With some reinsurers having agreed to the inclusion of perils such as cyber, expansion of the hours clause and other coverage widening, it is possible that some are already underwriting at or below their true cost-of-capital if the additional exposure assumed was factored in, we would suggest.

Moody’s says that the most important factor that could swing their outlooks is now a large U.S. hurricane or earthquake event, given that approximately 65% and 45% of ILS and cat bond capacity is exposed to these perils.

The occurrence of a major loss for either of these two core cat bond perils could have the effect of either legitimising alternative capital as a substitute for traditional reinsurance, or could cause buyers and regulators to view ILS with more caution if there are any willingness-to-pay issues. A large natural disaster such as this could also cause reinsurers to rethink their capital adequacy, which could also stimulate a reversal on pricing pressures.

So now that we’re out of the hurricane season that would suggest that a large U.S. earthquake could be the market changing event. However, we would note that for an earthquake to really impact the catastrophe bond market it would need to be so large that there is unlikely to be any such willingness to pay issues and in fact ILS capital may flood the market looking for new opportunities and to replenish exhausted capacity. That could actually exacerbate the pressure on reinsurers making life even more difficult for them.

The continued negative outlook from Moody’s is no surprise, neither is the rating agencies assessment of a further 10% decline in catastrophe reinsurance pricing to come. With the January reinsurance renewals on the verge of being wrapped up, reports we’ve heard reflect such levels of price decline. Reinsurers are having to be selective, but at the same time we hear that ILS capital continues to make headway and some ILS managers have been able to accept new inflows to put to work at the end of the year.

The reinsurance industry either needs an event to shake it up or we are almost certain to see some consolidation in 2015. It is hard to imagine how every reinsurer can survive when the return on their reinsurance business underwritten comes ever closer to the breakeven point and at the same time ILS capital continues to penetrate the market. The outlook serves to make reinsurer expense management and efficiency look increasingly important, issues we expect to hear a lot more of over the coming quarters.

Also read:

 – Renewal rates to drop as alternative capital drives secular change: Analyst.

– Consolidation may be a natural outcome for reinsurers: EY.

– Insurance and reinsurance mergers and acquisitions to increase: Fitch.

– Insurance buyers look to cat bonds, collateralized alternatives: Marsh.

– Efficiency, flexibility and effectiveness to drive reinsurance buying.

– Property catastrophe reinsurance rates to stay pressured in 2015: Swiss Re.

– Weaker terms erode reinsurance economics, introduce unmodeled risk: RenRe CEO.

– Charman: Reinsurance market to be challenging for foreseeable future.

– Reinsurers expense management & efficiency increasingly important.