[Originally published on 8/14/2014]
The increased competition in the global reinsurance market, created by excess capital which is driving down rates, could threaten the ratings of global reinsurers and create greater volatility in their earnings, warns Standard & Poor’s today.
Ratings agency Standard & Poor’s has published its latest analysis on the state of the global reinsurance market and the growing pressure market conditions are placing on global reinsurers credit ratings. Competitive pressure is the theme addressed in the report, with S&P saying that it is this competition that is driving down pricing and reinsurance rates, which as a result threatens reinsurer profitability, margins and earnings.
S&P has been saying for nearly a year now that reinsurance company credit ratings are under increasing pressure, leading to it placing the sector under a negative ratings outlook. The rating agencies commentary is getting more targeted now, highlighting key issues that will affect reinsurer profitability and the sectors outlook with this report perhaps being its most focused on these rating pressures to-date.
Of course this all comes down to the record high-levels of reinsurance capital, both traditional with reinsurers almost all holding excess capital currently, as well as alternative or non-traditional, with increasing capital market investor money accessing the reinsurance market through insurance-linked securities (ILS), largely in ILS funds and instruments such as catastrophe bonds or collateralized reinsurance.
S&P says that in its view it is increased competition which is causing the decline in reinsurance premiums, with third-party capital fueling the fire of excess capacity, exacerbating the problem for reinsurers.
The knock-on effects of this could affect reinsurers competitive positions, says S&P, as well as their ability to maintain their financial strength. Another threat created by competition is a heightened potential for earnings volatility caused by the much weakened pricing.
S&P notes that global reinsurers are doing what they can to mitigate the impacts of the increased competition and the reduction in reinsurance premium rates. So far, S&P says it has not seen material signs that reinsurers have succumbed to the temptation of using lower pricing to secure market share.
It should be noted that this does not align with the opinion of many in the market, who do say that some reinsurers have been accepting too low pricing and over-expanded terms at the recent renewals in order to secure signings and maintain their position on programmes. It will be interesting to see how this plays out, if any events occur which show any loosening of discipline, and who is right.
S&P notes that in response to the competition, reinsurers have been seeking out more profitable opportunities, something that other observers believe could actually exacerbate and broaden the softening of the market, as well as shifting investment strategies towards riskier assets as they try to increase their returns. Large reinsurers are pulling-back from the most price impacted areas of the market and smaller reinsurers are teaming up to place larger lines.
Despite all of this, S&P warns that ratings on reinsurers are the most sensitive to changes in the agencies assessment of their business risk profile or their risk position.
It will be particularly interesting to see how the changing investment strategies of some reinsurers get assessed should they suffer any decline in investment returns, or even volatility, as a result. Given S&P’s slightly negative assessment of the hedge fund reinsurer strategy in the last week, the adoption of riskier asset-side strategies could be one area the rating agency will be keeping a close eye on.
It will also be interesting to see how some reinsurers are putting more of their capacity to work in casualty risks, or other medium to long tail classes of business and whether the combined ratios can be managed to make this shift profitable over the longer-term.
The outlook isn’t looking any better either. Large cedents are continuing to rationalise their reinsurance buying at the group level, resulting in smaller buys and more diverse use of new and alternative capital sources. This hurts a particularly competitive and over-capitalised reinsurance market, once again exacerbating the issues affecting them.
This affects the smaller and less well-diversified reinsurers the most, especially the property catastrophe specialists, who can struggle to make themselves stand out at renewal time. S&P expects these players will feel the market pressures the most and it warns that is could reflect their weaker competitive positions, heightened industry risk and perhaps lower earnings in their ratings. This is perhaps the most direct warning on reinsurer ratings that S&P has given to date.
S&P focuses on the business risk profile, saying that any downward revision to this could result in a negative rating action. For some of the reinsurers which have been most cornered by the competitive and soft market, this could be a real risk in the coming quarters.
Any reinsurers relying on reserve releases, adopting significant changes in strategy, some of those adopting third-party capital management but with share-holder capital size expense ratios, or those who pull-back so significantly that earnings decline, could perhaps be the ones to watch for potential rating actions.
S&P notes that it expects merger and acquisition activity will be high on some well-capitalised re/insurers agendas, in particular those with excess-capital looking to acquire growth opportunities and scale. M&A may be the easiest way to do this without putting their business profile at risk.
S&P notes that those who have relied heavily on reserve releases in recent years may find these will diminish between 2014 and 2016, which we would imagine could leave them with nowhere else to turn. At the same time, S&P expects the softening market will reduce the sector's operating performance in 2014 and 2015, compared with previous years. This could affect reinsurers ability to generate capital organically, S&P warns.
Interestingly, S&P notes that releasing prior year reserves helped boost the sector's combined ratio by an average of 8 percentage points, which effectively makes the average combined ratio of 84.8% which was achieved, potentially higher than the five-year average of 90.7%.
If reinsurers are maintaining profitability and keeping combined ratios down using prior year reserve releases, what happens when these releases run out? With softening continuing, competition seemingly increasing and interest from the capital markets not going away reinsurers may be heading for a very difficult period.
S&P says that any increase in competitive pressures, a reduction in earnings or an increase to industry risk in certain segments, could cause its outlook on specific reinsurers to turn negative. Capital cushions may push the chance of negative ratings actions out, but over time, market conditions may begin to bite and the chance of some reinsurers being assessed as having a negative outlook may grow.
S&P’s report provides a look at the 23 global reinsurance companies that it rates, their current risk levels and how they are assessed. It’s a useful reference for those monitoring the performance of reinsurers going forwards.