Where are the margin improvements? A question worth asking…

As we approach the mid-point of the quarterly reporting season, a number of analyst firms are asking a very pertinent question. Where are the margin improvements in reinsurance, given the much improved rate environment?

It’s a question worth asking, as we’ve now seen compounding rate increases across most reinsurance lines of business since the early 2018 renewal seasons.

Analysts feel that reinsurance underwriters should be able to deliver higher margins on their underwriting portfolios, effectively a higher return per-unit of risk written, because of this improved rate environment.

Which is a fair assumption.

Reinsurance executive teams have gone out of their way to tell us that they are charging higher risk-adjusted rates, talking up the firming market and the opportunity that presents to their underwriting teams.

Analysts and shareholders have been listening to these comments for a number of years now, but with evidence so far lacking, it’s beginning to lead to questions.

The firmer reinsurance market environment means reinsurers should be generating more margin per-unit of risk written and expecting this to become evident in their results seems reasonable.

Of course, there are a range of reasons why some of the largest specialty underwriters and reinsurance firms aren’t yet displaying margin improvements on their reinsurance books. It’s not always easy to see through their reporting and with two sides to the business, underwriting and investment, reinsurers have levers they can pull which can mask effects.

We’ve had loss activity, not least from the COVID-19 pandemic, a lot of which has not yet even been fully reported to the reinsurers, as a majority is still IBNR.

On top of that, we’ve had ongoing catastrophe and severe weather loss activity, coupled with social inflation across property lines in the United States, which has particularly impacted the carriers most active in that countries wind-exposed states.

At the same time, social inflation is also eating into longer-tailed line profits and as a result must be impacting margins there as well, we assume.

Which boils down to attrition and this has had an eroding effect on margins, even when the incoming premiums come with higher margins attached, so far.

Some analysts suggest it is higher attritional loss ratios that are the cause.

This is beginning to raise some concerns among large investors in the insurance and reinsurance space, who have noted the inability of certain companies to reduce attritional losses over recent years, even as portfolios have been trimmed of catastrophe exposure, limits deployed have moved up the tower and third-party capital been used to absorb volatility.

But it’s not just attritional loss ratios, the stubbornly high expense ratios are also increasingly being cited as a driver of margin erosion, as for some companies in the market expenses haven’t fallen despite years of “digitalisation” initiatives having been undertaken.

If you think about the evolution of reinsurance over the last two decades, most of it should be designed to help companies deliver a higher margin, or more profit per-unit of risk underwritten.

Technology is supposed to bring efficiencies and should help to reduce the cost of underwriting capital, while also bringing down expenses.

The reinsurance industry is well over two decades into its digital transformation, but as of yet we haven’t seen a truly digital reinsurer, or evidence of true digital enhancement to the bottom-line.

Other expense related initiatives have similarly not driven the margin improvements shareholders and analysts have been looking for.

Third-party reinsurance capital, in insurance-linked securities (ILS), or other self-managed forms, should also be helping to lower the cost of reinsurers underwriting capital.

Reductions in expense ratios, use of technology to hone underwriting, use of third-party capital to lower cost-of-capital, there’s been a lot going on that should have raised reinsurer margins even without higher pricing being available, it seems.

Today, there are some signs beginning to emerge that margin improvement will begin to flow through, but it seems this won’t be evenly distributed, despite the fact everyone underwriting reinsurance is exposed to the same rate environment.

Disciplined underwriters that have cut back on aggregate exposure and areas that can cause attritional losses are expected to see the most immediate margin related improvements, while those that haven’t may find themselves still exposed to these questions.

As net grows ahead of gross, some reinsurers will benefit from this earning through their ability to retain more risk, after having pruned and optimised their book over the last few years.

For some, these earned premium effects will become very evident in the next year or two, we suspect, loss activity allowing.

Those that didn’t take this opportunity, of improving quality at the same time as gaining rate, may be disappointed and find analyst and shareholders share that feeling as well.

But, thee one thing we have in common with the analysts and investors is in feeling that margin improvement is going to be driven by rate increases and portfolio management for at least the next few years, not by efficiency gains or after digitalisation.

Despite the modernisation of reinsurance being well-underway, it seems the true benefits are yet to be realised in a meaningful way and very few players can really demonstrate how the investments and capex is returning efficiency dividends, so far.

To summarise.

The margin improvements are coming, but they won’t be evenly realised across the reinsurance market.

Those that prepared the ground and their books better, stand to benefit the most.

But the efficiency gains made from technology, expense management and also the use of third-party capital within their businesses remain largely disappointing for analysts and shareholders, despite the more than two decades of effort put into developing them.

Of course, there are companies that clearly benefit from the evolution of their business models over the last two decades, including each of the factors we mention above. For others, it can take a significant amount of time for benefits to outweigh the costs, particularly in areas like digital transformation.

However, it’s hard for analysts and shareholders to appreciate these, without clear information on the way initiatives and investments made, such as in the use of third-party capital, benefit a reinsurers business.

So perhaps reinsurers also need to do a better job in presenting their financial data, to make clear how investments they are making are driving any improvements in margins and returns.

That clarity, for example breaking out the effects of third-party capital, or attempting to quantify the benefits of digitalisation, would certainly help to answer some of the questions currently being raised.

Companies that can’t demonstrate the effects of pricing in their results are likely to face increasing questions and pressure from their shareholders and the analyst community.

At the same time, we’d suggest they should also be asking whether the reinsurers they care about are buying protection as efficiently as they can, using technology in the right ways, accessing lower-cost capital to enhance their performance as well.

The insurance and reinsurance industry has often avoided too much scrutiny due to the complexity of business models, but by taking up market pricing, their ability to innovate and transform digitally, insurers and reinsurers have encouraged greater scrutiny and we expect shareholders will become increasingly vocal over the coming years on topics from margins, to efficiency and expenses.