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The first downturn when reinsurers still make cost-of-capital: J.P. Morgan


Despite the fact that reinsurance prices have been softening consistently over recent years and are forecast to continue to do so, albeit at declining rates of decline, the big four European reinsurers could still cover their costs-of-capital, according to analysts at J.P. Morgan.

If that’s the case then this would be the first reinsurance cycle downturn when large, global reinsurance firms Munich Re, Swiss Re, Hannover Re and SCOR all make sufficient returns to cover their cost-of-capital, even at the very bottom of the cycle.

Analysts at J.P. Morgan Cazenove estimate that these reinsurance firms need to make a risk adjusted return on their capital of at least 8%. All four target a return above that level and seem likely to achieve that in 2016 as long as the wind does not blow severely and no major hurricane or industry losses are seen.

“The key point is that, excluding Munich which is undergoing restructuring costs for its primary insurance unit ERGO, on our forecasts the reinsurers we follow will either comfortably beat (Hannover Re) or at least equal (SCOR and Swiss Re) their ROE targets,” J.P. Morgan explains.

The forecast to beat cost-of-capital includes hurricane losses of an average level during the third-quarter. Should the season stay relatively benign, reinsurers could even comfortably beat, with a “windfall gain” possible and 2016 returns-on-equity clearly above targets, the analysts say.

If that happens the excess levels of capital in reinsurance will build further, resulting in further pressure on pricing and more capacity being diverted to primary insurance and other more profitable areas of the market.

The result of that could be a broadening of the softening, but with reinsurers still showing an ability to make cost-of-capital, although some forecast 8% could be a stretch should the softening pick up again at the key January 2017 reinsurance renewals, which may happen as pricing stability may not yet emerge.

“We believe it is significant that with normal hurricane losses three of the reinsurers we follow will at least achieve their target ROE, and comfortably exceed cost of capital of we estimate 8% for each group. This means that with current reinsurance pricing the reinsurers are still comfortably beating cost of capital with normal (ie inline with their budgets) catastrophe losses,” the analysts continue.

Of course, the J.P. Morgan team have only reviewed the four largest reinsurance firms, which are all globally active and have significant expertise at pricing and underwriting a diversified portfolio of risks.

“We believe that if pricing declines slow, ie the softening cycle declines more slowly, then this could be the first cyclical downturn we have seen where near the trough reinsurers are still covering cost of capital,” they said

Whether smaller, more focused reinsurance players can also continue to make their cost-of-capital at the bottom of the cycle remains to be seen.

With reserve releases still playing a significant role and catastrophe or major losses low, reinsurers may still continue to enjoy profitable years. Of course that situation cannot continue forever. Losses will rise and reserves may either worsen or dry up, to a degree.

But the longer cost-of-capital can be maintained the greater the chance that excess capital continues to build up, further exacerbating the issues reinsurers face. Not meeting cost-of-capital may be quite attractive to some right now, as it might just herald some sort of uptick in the cycle.

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