In a recent report on the global reinsurance sector, rating agency Standard & Poor's discusses the slowdown in the growth of ILS capital, which it said is "not due to lack of interest from investors" but rather indicates a pricing tipping point, in some peril regions.
Reinsurance pricing has continued to be under pressure in 2016 so far, from both the build-up of alternative capital, from insurance-linked securities (ILS) investors and funds, total return reinsurers and other efficient capital plays as well as continued excess traditional capital being wielded by reinsurers.
The expectation for the year and future renewals is for pricing to remain pressured, with declines in most lines, albeit perhaps at slower rates than seen over the last two years, especially in property catastrophe risks where risk appetite has been reached for many underwriters and investors.
S&P noted in the report that alternative capital grew more slowly in 2015, although still reaching a record at approximately $70 billion of capital deployed. The slowdown in growth of ILS and alternative capital is not a sign of waning investor interest though in its view, S&P said.
Instead, the slowdown in ILS capital growth is a sign of a pricing tipping point having been reached, in certain peril regions, where traditional reinsurance capacity has once again become cheaper than capital market investor-backed ILS capacity.
"Traditional reinsurance pricing has once again become more economical than alternative solutions, in some regions," S&P explained, something that has become increasingly apparent through the first quarter of 2016.
Dennis Sugrue, Senior Director, Reinsurance at Standard & Poor's explained; "Based on the feedback we've received from the market, that tipping point we've referred to was mainly with regards to European wind risk. In this region, the cat pricing has been less profitable and declining for some time, and ILS demand has been less pronounced in this region as well. So I believe the gap between ILS and traditional capacity for that risk has been narrower in recent years than for US wind or EQ."
We wrote about this in December 2015, as the January renewals were nearing completion, that some of the European reinsurance renewals were being priced aggressively at levels below the expected loss of even the most conservative risk models.
This pricing tipping point is evident in regions outside of Europe though.
Just the other day we spoke with the California Earthquake Authority (CEA), which said that catastrophe bonds are currently hard to justify given the cheaper cost of traditional reinsurance capacity for California earthquake risks.
The same has been clear in the European catastrophe perils, such as European windstorm, earthquake and multi-peril contracts, for some months now. In fact at the January 2016 renewals there were many reports of ILS players pulling-back on European renewals, given the aggressive price cutting seen.
European windstorm risks have become a smaller part of the catastrophe bond market in recent years, as traditional reinsurance capacity has been extremely competitive on price in the region. But even without the additional structuring and legal costs of a cat bond, ILS capital appears to have slowed its growth in this region on a collateralized reinsurance basis as well.
Another region where this pricing tipping point has become evident is Japan and Asian perils, where traditional reinsurance capacity has been increasingly competitive and, for the cedents, cost-effective.
The diversification effect, of large, global reinsurance players, is in full-effect in these regions. With major reinsurers able to discount some risks as diversifiers to others within their portfolios.
In fact, some of the world's largest reinsurance firms admitted that certain lines of business and regions are no longer expected to meet their underwriting cost-of-capital, at current pricing levels. But that doesn't mean an instant pull-back, given the diversification margin they can leverage, it does however mean discipline is vital.
Often the ILS fund managers do not have the ability to discount to the same degree, on a diversification basis, preferring instead to allocate capital to the reinsurance programs from large cedents which typically value the counterparty risk diversity and fully collateralized nature of their products.
That's not to say ILS managers don't participate in these regions, they do, but it does tend to be on the larger reinsurance programs, or catastrophe bonds, while many of the smaller programs are swallowed up by large global reinsurers.
This pricing tipping-point is an interesting market feature right now, as reinsurance pricing has neared a floor, or in some cases technical levels. It signals the need for the utmost discipline when underwriting these diversifying risks, in order to ensure unexpected or outsized losses aren't suffered.
And it seems, from S&P's and other observers or market participant's comments, that ILS players are displaying discipline in not allocating capital at any cost. In fact it's encouraging that this pricing tipping point has been noted, as it is another sign of ILS manager discipline.
The question of whether reinsurers have been taking on too much risk, by underwriting at levels that won't meet cost-of-capital or are nearing expected loss. The rating agencies are clearly aware of the risk this could pose to any company that over-exposes itself to a particular regions perils at very low pricing levels.
We asked Sugrue of S&P what would concern the rating agency and how it monitors the health of reinsurers that may be nearing the limits of pricing.
He explained; "Reinsurers have consistently said that the business they're writing is meeting their cost of capital. But we understand that some companies are looking at business on a client by client basis, rather than line by line.
"This approach can mean that a reinsurer is willing to take a loss on some business lines if the profitability for the client account as a whole meets their targets. We follow this approach closely and factor in our view of a company's ERM and underwriting discipline when assessing the company's risk."
And on the topic of diversification and how healthy an approach this is, in a reinsurance market that continues to soften, Sugrue said that S&P is wary; "We do worry about the risk that companies are overplaying the benefit of diversification, or that companies are underwriting based on marginal capital allocated; in which case the return needed to exceed the capital allocated can be much less than if the business was underwritten on a standalone basis."
For the rating agencies, such as S&P, there could be an interesting year ahead as they delve into reinsurers results and performance metrics. Of course it could take some much larger loss events, than we've seen in recent years, for any lack of discipline to be exposed.
There is, of course, a risk that if price pressure continues reinsurers will find pricing becoming less palatable in even the areas of the market where they have been diverting capacity, due to more attractive returns.
"As competition in those lines increases, the problems associated with pricing spill over, or get worse. If alternative capital finds its way to nonproperty lines and begins to affect prices there, as it has in the property-catastrophe segment, it could exacerbate the situation," S&P's report explains.
Sugrue said that S&P will be keeping a close eye on the market as this softness continues; "This will be an area of focus for us as we speak to reinsurers through the course of this year's reviews. Again, we will look to underwriting risk management, ERM and our assessment of companies' capital modeling capabilities to inform our views."
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.