Reserve releases for property & casualty insurance and reinsurance companies are expected to shrink over the next few years, with what was 15% of operating income on average falling to 11%, presenting a real risk to P&C re/insurer earnings, according to Morgan Stanley (NYSE:MS) analysts.
Reserves have been seen to boost insurance and reinsurance profitability in recent years, particularly for the P&C sector, however the contribution that reserve releases make to income and earnings is expected to slow down, with increasing risk seen to companies reserve buffers.
Analysts at Morgan Stanley, led by Xinmei Wang and Jon Hocking, suggest that, as underwriting and investment returns remains depressed, a slow down or shrinking of reserve releases could present not just a threat to earnings, but also an additional pressure to re/insurance company balance sheets
Analysis from the analyst team shows that while European property & casualty insurance or reinsurance companies still have reserve buffers in place, they are at differing levels and coming under increasing pressure.
Clearly those re/insurers with stronger reserve buffers and more sustainable reserve releases are those favored by the analysts, but they do believe that the market and shareholders are "underestimating the negative impact of reserving risk on earnings in a declining price environment, with a potential to see reserve charges."
If reserves halved the analysts believe this could result in as much as a 5% reduction in earnings, or 6% reduction for the P&C reinsurers.
That's quite a drop in earnings, one which shareholders should be aware of as a possibility. Once again, this highlights the importance of efficiency in re/insurance underwriting. With the reinsurance pricing cycle potentially altered, or flattened, for good thanks to the entry of efficient and lower-cost alternative capital, and with the impacts that is now having on some insurance lines, there is an increasing need for re/insurers to protect every percentage point of their earnings.
The Morgan Stanley analysts warn that there are signs that reserves may need strengthening emerging in the U.S., with U.S. commercial auto underwriters and companies such as Zurich (OTCQX:ZURVY) and Allianz (OTCQX:AZSEY) all taking reserve charges recently.
In fact, AIG (NYSE:AIG) revealed a reserve charge just yesterday, with adverse development on longer-tailed risks in U.S. & Canada casualty lines ($2.2B), U.S. & Canada financial lines ($0.6B), and runoff lines ($0.5B), requiring a total of $3.6 billion of reserve strengthening.
AIG is often seen as a bell whether for reserve strengthening, with an expectation that when the company takes a reserve charge others are likely to follow.
These reserve charges in the U.S. could signal that something similar may happen in Europe, and the analysts warn that claims inflation increases could be a driver of charges.
Recently, reserve releases have actually been driven by shorter-tailed lines of business, such as property catastrophe risks, according to the analysts, but at the same time the reserve buffers in liability and longer-tailed lines have been dwindling.
While reserve buffers remain positive across the industry, recent booking of reserves appears to be getting less conservative, the analysts say, a sign of them diminishing perhaps.
If natural catastrophe loss activity reverts back to more normal levels, or longer-tail lines experience claims inflation, the analysts warn that pressure on these reserves could increase even further, adding risk to earnings and balance-sheets.
This presents perhaps the biggest threat to reinsurance firms, particularly as the low catastrophe loss environment is not particularly conducive to building up big reserve buffers.
The P&C insurance and reinsurance sector has been flattered in recent years by light catastrophe losses and strong reserve releases, but if and when the music stops on reserves this flattery could come to an end fairly rapidly, resulting in the full pressure of the market dynamics suddenly becoming evident.
If reserve contributions to earnings halved, as Morgan Stanley suggests, then the true impact of the lower priced re/insurance environment will be seen in some companies results. Add in normalised, or perhaps above normal catastrophe loss loads, and things could like bad very quickly for some companies whose reserve buffers are smallest.
The analysts notes that historically the pricing cycle in insurance and reinsurance has reacted to reserve strengthening, with hard markets following periods where the market as a whole had to significantly strengthen its reserves.
But how would the market react today to this occurrence? It's likely that reserve strengthening in longer-tailed lines would only result in line specific hardening of prices, not across the market. In fact, as reserves are strengthened in some lines, the insurance-linked securities (ILS) sector could exert additional pressure on the shorter-tailed lines, preventing re/insurers from getting the price increases they would likely be seeking, or at least depressing them.
Market dynamics such as periods of reserve strengthening could in future become opportunities for more efficient risk capital and more efficient business models to take additional market share and to drive home their cost-of-capital advantage even more.
The Morgan Stanley analysts highlight the European P&C sector as having the greatest potential for weakness, with weaker pricing dynamics as well as stronger reserving headwinds. Add in any issues with expense ratios, or an inability to adapt to the new competitive market environment, and reserve shrinkage could mean trouble for some.
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