Top & bottom line, secular & cyclical. Reinsurance pressure abounds: Analysts

Pressure on the reinsurance market and its incumbent traditional players comes from all angles, with analysts from Bernstein Research citing top and bottom line margin pressure, along with both secular and cyclical pressures on the market and business models.

Analysts from Alliance Bernstein’s equity research division discuss the growing pressure on reinsurers and how this is leading to an increasing chance of consolidation, some of which it describes as ‘fear-driven M&A’, as reinsurance firms craft a response to the increasingly pressured marketplace.

In the report the analysts are commenting on the proposed acquisition of Platinum Underwriting by RenaissanceRe and the recent but unconfirmed news that another Bermudian reinsurance firm Montpelier Re may be considering its options, with a potential sale or merger a possibility. The analysts note that the two M&A cases have divergent approaches and question which is best, a specialist buying another smaller player or a specialist putting itself up for sale in the hope of attracting a larger buyer.

M&A strategies aside, the Alliance Bernstein analysts note that the latest announcement seems to confirm their thesis that in the pressured market environment consolidation is accelerating and that as pricing continues to decline in property catastrophe and other lines, the growing pressure on top and bottom line is likely to induce fear-driven M&A, providing both risk and opportunity for investors. Also see the announced yesterday XL Group approach for Catlin Group.

The analysts believe that property catastrophe reinsurance is clearly in a cyclical decline and expect this trend to continue for some time. The capital markets entry into and continued interest in catastrophe risks is a major catalyst for this decline. On top of the over-capitalised traditional reinsurance market this has led to fierce competition in a shrinking pool of opportunity, with the result being a commoditised market with the price set by the most aggressive seller.

Pressure on underwriting margins is expected to continue, the analysts say, with prospects for 2015 looking depressed. Further out the analysts say that they anticipate it as likely that traditional catastrophe reinsurance will continue its secular decline, as ILS and alternative products continue to take market share, particularly in markets outside of the U.S. where the penetration of alternative capital is already high.

For smaller property catastrophe focused reinsurers this is presenting an “existential challenge”, the analysts explain, as these niche players struggle to survive. This is adding heat to the M&A fire and this pressure is unlikely to go away without changes being made to business models.

Other lines, outside of property catastrophe reinsurance, are not immune to the pressure that reinsurers are facing, say the analysts. In fact, the Alliance Bernstein analysts are fairly negative about the prospects for a much wider swathe of the market than some others.

“We think there is a widespread misapprehension that extreme softness in reinsurance is confined to catastrophe reinsurance. This is simply not the case. Casualty reinsurers are also facing a market with severe pressure on pricing,” the analysts write.

They note the documented increases in casualty risk ceding commissions, the fact that treaties are often being priced to an expected underwriting loss and that these factors and the general affect of market wide softening are being felt in casualty risks from a much lower base level of profitability than property cat witnessed.

There is again a trend for less casualty reinsurance to be purchased by large reinsurers, while at the same time the sector is awash with capacity from traditional players, plus reinsurers attempting to avoid the pressure in catastrophe risks.

Smaller, following casualty reinsurers are feeling the pressure the most, in a similar way to that seen in property catastrophe reinsurance just a couple of years ago. The analysts believe this phenomenon will continue and the casualty reinsurance pie will shrink, as the catastrophe reinsurance one did.

New challengers, such as Watford Re, with capital from new investors in casualty risks, as well as some hedge fund reinsurers targeting casualty reinsurance risks, are exacerbating this issue, again in a similar way to ILS and catastrophe reinsurance.

The analysts say that it is not clear whether this is the beginning of a structural change, or just another soft market phenomenon. Either way they expect the demand supply imbalance to continue and margin compression in casualty reinsurance to be a feature well into 2016.

“In such a market, we expect it will be challenging for RenRe to turn the tide at Platinum, where premium volumes have fallen more than 50% over the past 7 years,” the analysts note, which suggests that the strategy to move premiums to casualty risk may not be the saviour that some reinsurers have been hoping for.

This scenario, of structural change spreading across the reinsurance market, as new players often with fresh capital come in, alongside shrinking demand as risk retention and the general understanding of risk transfer becomes more sophisticated, is a scary prospect for reinsurers.

The casualty risk scenario can be applied to specialty reinsurance business as well, where reinsurers have also diverted capital as they seek to avoid the competitive catastrophe market. If both specialty and casualty follow down a similar path of softening over the next two years, while property catastrophe shows no signs of becoming anything other than a commoditised market, where is left for smaller reinsurers to hide?

The analysts, who provide their research to equity investors interested in the insurance and reinsurance sectors, say that; “With potential upside from “post-event” constrained by new capital, reinsurers offer a poor risk/return, and this fundamental change has yet to be reflected in reinsurance stocks.”

Part of the attraction for equity investors in reinsurance stocks has historically been the ability of good reinsurers to generate outsized returns post-event due to capital scarcity. Now, with no guarantees that we will ever see the same capital scarcity again, unless an event of magnitude previously unimagined occurs, it is hard to envisage reinsurers being in such a position of luxury ever again.

Investors have in the past profited from the post-event, hard market boost to returns and the ratio of hard to soft years. The Alliance Bernstein analysts say that they believe that both of those factors will be materially lower in the future.

They are not calling for an end to cyclicality and permanently depressed pricing, they insist, rather they expect the re-pricing post-event to be of a much lower magnitude, much shorter in duration and much less broad-based (restricted to affected lines and geographies) than has historically been seen.

Convergence is a major factor in this as there is now a large pool of capital markets money that is interested in this sector. The belief is that if reinsurance capital is exhausted to a degree and return opportunities improve, it is this money that will come in to replenish the sector and pick off the best opportunities.

Convergence has also resulted in more efficient structures, through which capital can be more mobile and enter the market much more rapidly, reducing the lead time needed to raise and deploy new capacity to those that require replacement protection.

The analysts also note tat the availability of multi-year cover and free reinstatements is eroding the prospects for payback pricing and also eroding the post-event trading opportunities anyway.

The analysts report is yet another gloomy outlook for the reinsurance sector. In fact they advise new investors looking at the space to avoid reinsurance altogether until the market more realistically discounts share prices due to continued pricing and earnings pressure. When lower valuations emerge consider investing in smaller firms, they advise, which may be subject to being acquired, rather than larger firms which may look to consolidate.

Perhaps most concerning for reinsurers in this assessment is the view that casualty and other lines are perhaps facing structural change in the same way that property catastrophe reinsurance has. That trend is going to run through 2015 and it will be interesting to see how those markets continue to develop, with a likelihood that new capital will find its way in, even if not in as direct a way as ILS has into catastrophe risks.

To summarise; the Alliance Bernstein analysts believe that the returns made from catastrophe reinsurance business are in a secular decline, while casualty (and other) reinsurance lines are under increasing pressure. With an expectation that pressure is ahead for the next couple of years and the prospects of post-event payback are shrinking, scale is increasingly important to be able to acquire quality business and to still be there to reap any benefits that become available.

Some of these cyclical and secular factors are not priced into reinsurance stocks currently, making M&A tricky to price and the value of consolidation sometimes questionable if it aims to achieve diversification, particularly if the analysts assessment of casualty lines is accurate.

With pressure coming from the top and the bottom line reinsurers are increasingly feeling the squeeze, which is going to result in greater pressure to consolidate. But even M&A is no longer a panacea that is guaranteed to rescue a reinsurers prospects. If there’s nowhere available to hide, simply making yourself larger may not help your prospects (contrary to some beliefs).