Third-party capital adds fuel to fire for Bermuda reinsurers: S&P

Rating agency Standard & Poor’s said that reinsurance companies in Bermuda would be experiencing fierce competition even without the influx of third-party capital, but the addition of a growing pool of capital markets money is adding fuel to the fire.

The comments come in S&P’s latest report on the Bermuda reinsurance sector, in which it discusses the fact that Bermudian reinsurers have experienced reasonably strong results, despite the many factors which are conspiring to dampen their trajectory. These factors include the increased competition, both from traditional and non-traditional reinsurance sources, the low investment yield environment which dampens returns on assets and the tepid economic recovery in the U.S. and Europe.

Despite the clear headwinds, Bermudian reinsurers have managed to product strong earnings, with the low levels of catastrophe losses and improving prior year reserve releases the main contributors. In aggregate, 20 reinsurers surveyed by S&P and Deloitte in Bermuda produced a combined ratio of 85.6%, up from 91.5% in 2012, and a return on average equity of 12.9%, up from 11.4% in 2012, strong results. These results support Bermudian reinsurers overall risk adjusted capitalisation, said S&P, which the rating agency views as a continued strength.

S&P’s latest report is titled ‘Barbarians At The Gates: Are Bermudian (Re)Insurers Victims Of Their Own Success?’, which might give you a hint as to where this article is going.

S&P says that among the hottest topics on the minds of the 20 reinsurers surveyed in Bermuda is the subject of third-party reinsurance capital and its growing influence on property catastrophe reinsurance rates and pricing.

“Although this mechanism has been part of the reinsurance landscape for decades, the influx of third-party capital has increased significantly over the past couple of years,” commented Standard & Poor’s credit analyst Taoufik Gharib.

Bermudian reinsurers underwrite approximately one-third of global property catastrophe business, which gives you an idea just how big an impact the growth of third-party capital over the last few years has been. Third-party reinsurance capital, also referred to as alternative capital, convergence capacity and collateralized reinsurance, is having an increasing impact on the rates that Bermudian reinsurers can command which further increases competition for the available pool of property catastrophe reinsurance business.

Third-party reinsurance capital is now disrupting reinsurance business models, said S&P, which on top of the increasing competition from traditional reinsurance firms will likely hurt Bermudian reinsurers profitability in 2014 and 2015 and could even threaten some reinsurers market positions.

S&P warns that it could lower its ratings on any reinsurers that it deems to have aggressively tried to maintain market share by competing on price or by relaxing underwriting discipline, while their profits slip.

S&P revised its outlook for the global reinsurance sector to negative earlier this year, as it forecast that the increasingly competitive behaviour of reinsurers would lead to a reduction in profits in years ahead. This, however, is the first real warning to reinsurers that if profits are coming down and they continue to fight hard to keep hold of business, perhaps further reducing profitability in the process, their ratings will suffer.

S&P says that competition from the influx of third-party capital is only adding fuel to the fire for these reinsurers, applying even greater competitive pressures and helping to ensure rates are squeezed to the maximum. Traditional reinsurers are increasingly keen to put excess capital to work which is helping to bring rates down. On top of this, with large cedents rationalising their reinsurance purchasing behaviour, including some moving to a group buying approach, the number of reinsurers participating in some program renewals is reducing.

As a result of all of this increasing competition and reinsurance purchase streamlining, S&P says that competition among the Bermudian reinsurers would have been fierce even without the recent surge in third-party reinsurance capital.

“We think that companies without a defendable competitive position, or those that are more aggressive in maintaining market share by competing on price or relaxing their underwriting discipline, are most at risk,” said Gharib. “We could revise our assessment of those (re)insurers’ business risk profiles to reflect the relatively higher risk. In addition, we believe Bermudian (re)insurers with diminished capital buffers, or those whose earnings capacity is persistently constrained, could face rating pressure.”

In the survey, reinsurers ranked their top business issues as; reinsurance renewal rates, investment returns, controlling costs, regulation and growing market share vs profitability.

It’s no surprise to see renewal rates as the number one concern, with reinsurance pricing heading for ever softer levels this is the main threat to profitability right now. Investment returns is again not really surprising, there is already an emerging trend which sees reinsurers investigating taking on higher risk and return asset side strategies. Again, cost control is no surprise, reinsurers expense ratios will be the first area to come under scrutiny as profits decline.

S&P says that it does not foresee a reversal to the pricing trend for at least the next couple of years, barring a major catastrophe loss event, dramatic capital markets adjustment or adverse reserve development shaking up the market. Further price declines are expected at the upcoming mid-year reinsurance renewals, although S&P would only say it expects to see ‘meaningful’ rate declines.

S&P highlights the many ways that reinsurers have been looking to harness or work with third-party reinsurance capital. These include the use of the capital markets for retrocession, establishing third-party capital management units, launching sidecars and launching reinsurance funds.

S&P is not convinced though, the report says; “Despite their efforts to either combat or harness the flow of capital, we believe the net effect for Bermudian (re)insurers is negative. They will have difficulty adjusting when what has generally been their most profitable line of business (in years with light-to-average catastrophes losses) rapidly loses pricing power and becomes increasingly commoditized.”

S&P says that an extreme outcome of this trend might be for Bermudian reinsurers to become risk conduits for capital market money, instead of the primary risk bearers. S&P says that the push in this direction cannot be denied.

S&P also warns reinsurers from relying too much on ‘potentially flighty retrocession capital’, and not to risk being lured by the temptation of arbitraging the rate gap between incoming catastrophe premiums and outgoing retrocession.

S&P makes some very good points here. There is already discussion of reinsurers arbitraging the risks they hold versus those they cede to the retro or capital markets, hoping to offload risk for a cheaper rate than they can assume it, thus keeping a small profit.

Equally the comment that reinsurers are becoming conduits for risk is very relevant in the market right now. There is also discussion of reinsurers underwriting additional risk in order to deploy capital market money they have raised. While this gives reinsurers a lower cost of capital it can also reduce their value added services down to that of risk or underwriting analyst and a conduit of risk to capital.

S&P also notes that Bermuda itself stands to benefit from the third-party reinsurance capital trend, with many specialists establishing themselves on the island. S&P notes; “The amount of reinsurance placed in the Bermuda market could grow, especially if third-party capital deepens its reinsurance presence for exposures outside of North America.”

Another key point made by S&P is that the recent inflow of third-party reinsurance capital has been driven by supply, from investors seeking to access insurance and reinsurance as a long-term asset class. In the past, such as in 2005, the inflow has been driven by demand for capacity. Supply-driven inflows of capital markets money may prove more sticky than those pulled in by the lure of demand.

S&P discusses the stickiness, or otherwise, of the ILS and third-party reinsurance capital, saying that some will likely be in the reinsurance sector for the long-term, while some may also be more prone to withdraw after an event.

S&P explained; “We believe that long-term investors, such as pension funds, generally appreciate these risks and are not making outsized allocations to catastrophe risk. Consequently, they are less likely to retreat.”

But on potentially shorter-termist investors, S&P said; “A large portion of the market consists of opportunistic investors, such as hedge funds, that may focus more on short-term gains. These investors could quickly move to other parts of the market after a loss or if another asset class is simply more attractive.”

But while the size of the third-party reinsurance capital market may fluctuate, with capital ebbing and flowing in and out of the market in-line with the occurrence of major catastrophes, pricing cycles and other capital market factors, S&P believes the amount of capital market money at play in reinsurance will remain significant.

S&P closes the report by saying that Bermudian reinsurers will remain under the rating agency’s watchful eye; “We’ll focus heavily on Bermudian reinsurers’ underwriting discipline, rate adequacy, and profitability prospects for the next 12 to 24 months. Many of these companies will prove successful in navigating this soft market by adhering to established underwriting and risk controls. It will be those companies at the margins and those that relax their rigor that likely succumb to consolidation or suffer negative rating actions.”

So the warnings about an increasing squeeze on property catastrophe focused reinsurers continue to emerge. S&P is the first to single out Bermudian reinsurers and warn that any reinsurers it deems to be taking too many risks, for too little reward, could come under rating pressure.

We expect statements of this kind to increase after the mid-year renewals, once the scale of any additional rate declines are understood. Then as we move through the rest of the year, should the market continue largely free from major losses, we may see this rating discussion increase in volume heading towards January and some specific firms begin to feel the pressure.

S&P’s full report can be accessed here by subscribers to its services.

Here are a selection of recent articles from Artemis which discuss these reinsurance market trends and its outlook:

– Fitch reiterates negative outlook for global reinsurance sector.

– The capitalisation of the reinsurance business is changing.

– Reinsurance downside risks grow, June renewals will test: Moody’s.

– Consolidation ahead for smaller reinsurers: Munich Re CFO.

– Reinsurance prices to drop by double-digits at June renewals: Fitch.

– Alternative reinsurance capital grew 28% to $50 billion in 2013: Aon Benfield.

– Capital market threat could be reinsurance game-changer: A.M. Best.

– Watford Re, and start-ups, a blank canvas for reinsurance innovation.

– Reinsurance renewal prices fall by as much as 20% across sector.

– Alternative reinsurance capital to grow to $100 billion: BarCap.

– April’s reinsurance renewals to show alternative capitals influence.

– Traditional reinsurers challenged to compete on cost-of-capital .