Reinsurance company claims reserves are beginning to run low meaning that the releases seen in recent years to boost profitability in a softening market may not be as easy to continue, according to CEO of Allianz Re (OTCQX:AZSEY) Amer Ahmed.
Speaking to Bloomberg in an interview in Munich, Ahmed said; "I don't think there are too many loss reserves left and the natural-catastrophe bill can't remain low forever."
We've been writing about the contribution that reserve releases have been making to reinsurer results for some time, as observers increasingly point to the fact that with the market remaining free of severe catastrophic loss events these reserves are perhaps not being replenished as quickly as some players need in order to continue releasing at the same rates.
In fact recently we wrote about analysts at Morgan Stanley's opinions that reserve releases had been contributing as much as 15% of operating income, which they expect will fall to an average of 11% for 2015 to 2020. Further, they noted that if reserve releases halved it could result in a hit to P&C re/insurers earnings of as much as 6%.
As a result of its research the analysts said they believe that the market has been "underestimating the negative impact of reserving risk on earnings in a declining price environment, with a potential to see reserve charges."
Ahmed seems to agree.
"Reinsurers are still generating positive returns as low natural catastrophe claims and reserve releases from business written in the past are helping offset depleted investment returns," he told Bloomberg in the interview.
However the expectation that releasing of reserves may begin to slow down suggests that there is another risk facing a reinsurance market, to add to the fact that it may have been underwriting at levels close to, or even below, cost-of-capital while expanding contract terms as well.
Ahmed told Bloomberg that while he doesn't feel further sharp declines in reinsurance prices are likely, he doesn't yet see a turnaround and ongoing single-digit rate declines are possible.
Reinsurance firms remain under pressure from the effects of an over-capitalized industry, caused by a number of benign loss years and the influence of growing amounts of alternative and ILS capital.
This has resulted in a steady and continued softening of reinsurance pricing, while at the same time competition has been rising which increases the pressure to expand contract terms and conditions.
So in a market where some players have been underwriting catastrophe risks at lower prices, with in some cases vastly expanded terms, resulting in the assumption of greater risk exposure, one of the levers driving continued profitability could begin to dry up.
Ahmed told Bloomberg that Allianz Re has cut back on some contracts, due to price and competition, at the January renewals, as it seeks to maintain discipline.
What does this all mean? As we've written many times before it makes the efficiency of risk capital increasingly important, which does favour the ILS market in some circumstances.
If reserves do begin to dwindle and reinsurance firms lose a number of percentage points of earnings as a result, the efficiency of their risk capital will become vital, with pressure then likely to return to the expense ratio and managing the combined ratio down to below 100% in order to maintain a reasonable return on equity (ROE) to investors.
Any company that struggles to achieve this could see pressure increasing rapidly, potentially making weaker firms real targets for M&A as the opportunity for larger reinsurers to consume the smaller may suddenly become a very real and attractive prospect (and the only way out for shareholders).
Of course those reinsurers that have continued to prudently, or over, reserve for every possible loss even in the more benign years can likely carry on releasing enough to maintain profitability, at least at some level. It will be those whose reserving practices have not been as prudent that could suddenly look less profitable.
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