Standard & Poor’s notes that were it not for the benign catastrophe loss experience of recent years and higher reserve releases reinsurers’ return on capital would have failed to exceed cost of capital levels in 2015 and so far in 2016, suggesting that a truly soft market is nearing.
The profitability of global reinsurers has been under threat for some time now, with the cost of capital of reinsurers rated by S&P declining since 2005.
However, in more recent years the benign catastrophe loss experience and substantial prior-year reserve releases has enabled companies to report solid returns in very challenging conditions, which, is masking true operating profitability.
“In our view, given a more normalized loss experience, the reinsurance sector’s overall profitability would not have exceeded its cost of capital, in either 2015 or so far in 2016,” said S&P, in a recent report examining the profitability of global reinsurers.
The reinsurance market remains overcapitalised as capacity from both traditional and alternative reinsurance providers continues to enter the space in search of yield and diversification.
Combined with the persistent low interest rate environment that has dampened returns on the investment side of the balance sheet, increased expenses and the benign cat experience, profits are becoming more and more difficult to come by.
“We now anticipate that reinsurers’ profitability will soon drop below their cost of capital and could remain there until the underwriting and/or investment cycles turn. This trend has significant credit implications, some of which will depend on how investors respond,” said S&P.
The international ratings agency states that at the end of 2015, and for its group of rated reinsurers, the cost of capital for the sector was 6.6%, and the return on capital stood at 8.5%, representing a margin of 1.9%.
However, by August 1st 2016 the margin had declined to roughly 1.6%, as the cost of capital of S&P’s cohort declined to 6.2%, suggesting that the return on capital fell further to 7.2%.
S&P attributes further decline in the group of reinsurers’ cost of capital from the end of 2015 to the beginning of August to a number of forces including; lower cost of equity, a reduction in the cost of debt, an increase in the percentage of debt funding reinsurers’ balance sheets today vs equity funding, and the increased supply of capital from various sources.
The ratings agency predicts that reinsurers’ return on capital will fall to between 5.5% and 7.5% by the end of 2016, and that the sector’s cost of capital will fall to roughly 6% over 2016 and 2017.
“Therefore, even assuming continued favourable prior-year reserve releases and benign natural catastrophe losses, we anticipate that reinsurers will barely cover their cost of capital over the next two years. More normalized losses and prior-year releases (as already demonstrated by some reinsurers during the first half of 2016) will result in the sector’s profitability dipping below its cost of capital,” warns S&P.
Some reinsurers have been seen to aggressively release reserves in recent times in order to increase quarterly earnings and essentially ensure their profits exceed their cost of capital. But the aggressive approach from some and the lack of losses in previous years suggests that reserves could be running thin, and the ability to strengthen balance sheets this way might not be so easy for some.
Furthermore, and as highlighted by S&P, catastrophe losses in the first-half of 2016 increased when compared to more recent quarters and years, suggesting that some reinsurers might have little room to manoeuvre any adverse developments in the latter months of the year, such as a landfalling hurricane or significant winter storm, for example.
Currently, returns are still exceeding the cost of capital says S&P, but there’s very little chance the highs of 2005 (10.8% cost of capital) will return anytime soon as the series of market headwinds are showing little sign of abating.
S&P predicts modest interest rate increases for 2016 and 2017 and as such considers 6% a “reasonable floor for the cost of capital by year-end 2017.”
“Therefore, even assuming only a normalized catastrophe load, and assuming healthy prior-year reserve releases over the near term, it is eminently possible that by the end of 2016 (and the end of 2017), reinsurers’ return on capital will be no higher than 6% and flat to their cost of capital, which we would argue signals the start of a truly soft market for reinsurers,” said S&P.