Softening prices, resulting in reduced margins and lower profits, as well as a slight uptick in exposure to smaller catastrophes haven’t dented global reinsurers appetites for underwriting catastrophe risk reinsurance, according to Standard & Poor’s.
The price deterioration that has been witnessed across the global reinsurance market, which has been particularly evident in peak property catastrophe reinsurance markets such as Florida, combined with a greater level of exposure to smaller catastrophe events could weaken profit margins and increase earnings volatility, S&P explains in its latest report.
This will be most evident and potentially most impactful for reinsurance firms with concentrations in the most competitive catastrophe markets, while those larger, more globally diverse reinsurance players will be less impacted by this growing threat to maintaining their profits and expected returns.
With the reinsurance industry awash with record levels of capital, both in terms of traditional reinsurers shareholder equity capital and non-traditional or third-party sourced capital from investors and the capital markets, there is no sign of price pressure going away anytime soon.
While catastrophe loss levels remain far below the amount required to signal any turn in pricing, margins are expected to be continually and increasingly squeezed in catastrophe reinsurance markets. At the same time growing competition from alternative capital in the form of insurance-linked securities (ILS) such as catastrophe bonds and collateralized reinsurance from efficient markets such as ILS fund managers is expected to ensure the pressure remains on catastrophe focused traditional reinsurers.
The latest publication from rating agency S&P gives its view on how several of its key rating factors could be affected by the shrinking profit margins in the catastrophe reinsurance business over the coming years. S&P warns that capital and earnings volatility may increase which would weaken its assessment of a reinsurers risk position, while reduced profits may drive down its assessment of a reinsurers industry risk and competitive position.
S&P has been releasing a string of publications in advance of the coming Monte Carlo Rendezvous meetings, each looking at how current reinsurance market dynamics are playing out and affecting its ratings of reinsurers.
It does appear that S&P is preparing the ground for some expected downgrades at some point, possibly not in the too distant future, with these publications. Each describes why a continuation of recent market trends will increase rating pressure on those reinsurance companies which are most exposed to the changing market environment.
Of course ILS players are unrated, but these same reinsurance market trends clearly affect them in similar ways to reinsurers. However, the ILS players do often compete with an advantage of being a source of often lower-cost, more efficient capital with lower return requirements sometimes evident for core areas of the catastrophe market.
This means that the continuing market trends could actually create opportunities for ILS players to actually benefit from the challenging market conditions while other more traditional players may struggle in the face of dwindling profit margins and rising combined or expense ratios, some ILS players may be able to capitalise on this.
S&P’s analysis of key benchmarks, against which it rates reinsurers, leads it to believe that extremely strong capital adequacy is providing some resilience to the industry, which continues to show disciplined risk management.
That does suggest that if discipline wanes, or perhaps if capital adequacy is eroded by a number of smaller, attritional type losses which reduce industry capital but not to the levels required to trigger price hardening, that this resilience may be removed and reinsurers exposure to rating downgrades will increase.
S&P has only witnessed a modest change in reinsurers catastrophe exposure in response to the price decline, with exposure to a one-in-250-year annual loss to shareholders equity remaining only slightly lower than in previous years largely due to stronger capital positions. At the same time exposure to more frequent, one-in-20-year, catastrophe events has seen a modest uptick.
S&P believes that reinsurers are a little better protected in terms of retrocessional reinsurance cover for high-severity losses, with them being most exposed to 1-in-100 or larger loss years.
It is the Bermuda and London-based specialist catastrophe focused players which show higher than average appetites for catastrophe risk, while the globally diverse reinsurers are more inherently diversified. However, S&P believes that currently even the reinsurers with higher risk appetites are continuing to mange catastrophe exposures within well-defined risk limits.
S&P believes that earnings volatility may increase, reducing reinsurers ability to absorb losses. As part of this the drop in pricing may drive up loss ratios, in terms of how severely they may be affected by the largest of events. At the same time greater exposure to smaller catastrophe events may impact earnings in the future.
Also, S&P notes that the probability of negative underwriting on catastrophe business increases, as these trends play out. There is also a risk that the industry underestimates the present day impact of previous large losses, as should the worst loss of the last 10 years occur again S&P says the sector would lose on average 112% of annual profit.
One bright point for reinsurers is that alternative capital is making it cheaper and easier for them to protect themselves with retrocession, using instruments such as catastrophe bonds, industry loss warranties and collateralized covers. S&P does warn that over reliance on retro could result in issues around counterparty risk, should the largest catastrophe events occur. Of course this has not yet been tested and the ‘potentially unreliable’ capital S&P mentions may prove to be just as reliable as traditional reinsurance capital.
Also mentioned is the increasing trend for relaxation of renewal terms and conditions. This could increase both capital and earnings volatility, warns S&P. It may take some time for any volatility from these relaxed terms to show and it is losses that will reveal who has been taking on more risk than they perhaps should, or more complex risks than they perhaps understand.
The excess capital in the industry is acting as a cushion currently and could help many larger reinsurers to recover after even very major loss events. Smaller, more catastrophe focused reinsurers could struggle to recapitalise after losses, warns S&P, especially as alternative capital could be a more attractive avenue for investor money to replenish the sector and this could mute any chance of increasing future profits through flattening of the price cycle.
It is the least diversified that will face the most challenges, says S&P, but significant changes to business mix to try to avoid the worst pricing pressure also comes with its own risks. For the larger, global reinsurers, diversification is no longer a panacea, explains S&P, especially as prices are declining globally and entry into new markets or lines can be less profitable than the business being replaced anyway.
“In this context, the capacity to diversify business mix, risks, and exposure, as well as the ability to manage risk transfer efficiently and to deploy strategies to maintain competitive positions will become more important. We expect that conditions this year will test enterprise risk management capabilities within the industry as reinsurers more closely scrutinize their risk appetite management and underwriting discipline,” S&P explains.
If conditions in the remainder of 2014 and up to the January 2015 reinsurance renewals are going to test reinsurers, the conditions after January may be when any differences in success at navigating a challenging market begin to show through. Reinsurers are going to be watched closely, by rating agencies, analysts and the media alike, in times of increased pressure scrutiny will inevitably increase as well.
Read our other articles on S&P’s recent notes on the reinsurance sector: