Property catastrophe pricing is no longer as heavily influenced by the traditional reinsurance market as it was historically and is now "at the mercy of the alternative capital market" according to A.M. Best, who holds its 2018 outlook for the global reinsurance sector at negative.
Reflecting the increased influence that insurance-linked securities (ILS) and the alternative capital market now has in the reinsurance sector, A.M. Best says it is "concerned" by the fact that property catastrophe pricing could now be more influenced by the capital markets than by the traditional market.
The rating agency says that this is "an important distinction as regards current market dynamics," as any near-term improvement in prospects for reinsurers, following the major catastrophe losses of the third-quarter, may be relatively short-lived this time.
This is the flattening of the reinsurance cycle, which we've been forecasting for a number of years now, as the entry of long-term, patient capital from pension funds, the capital markets and ILS structures looks set to make the traditional market cycle very different in the future.
After the losses we've seen this year and with reinsurers calling for major price increases, the cycle of the past would have responded with steep price hikes across property catastrophe lines of business.
But A.M. Best suggests that the size of the price increases we see at renewals in 2018 will be more influenced by the appetite of alternative capital providers, as the market moves towards one where capacity drives the reinsurance cycle and the least conservative (or most efficient) may become the price setters going forwards.
The availability of capital and how it can flow in and out of the reinsurance market has changed dramatically in the last twenty years, since the first catastrophe bonds and ILS structures emerged.
Now, capital is fluid and elastic, meaning underwriters can bring it into their structures more quickly and simply than before, and this flexibility (of capital and structure) has now become not just the softener of prices, but the softener of the reinsurance cycle itself.
As a result, A.M. Best has heightened concerns for global reinsurers and while it believes the impact of major catastrophe losses could slightly improve reinsurance market conditions in the short-term, the rating agency keeps a negative outlook for the global reinsurance sector in 2018, saying that it sees "considerable uncertainty surrounding the level and sustainability of any market improvement."
In fact, ongoing market challenges had already depressed earnings in 2017 before the catastrophes came along, according to A.M. Best, which along with poor investment conditions has served to, "drag operating and overall performance to a level just marginally sufficient to cover the average cost of capital for many reinsurance-predominate companies."
The catastrophes on top of this has further eroded the historical profitability of the reinsurance segment, the rating agency notes, which could push reinsurers to fight even harder at renewals, especially in areas where prices do rise.
But alternative capital may be able to exert its capital efficiency to such a degree that it can take further market share, which would truly put property catastrophe pricing at its mercy.
While there had been concerns over the availability of alternative capital following the major losses, with a considerable amount of capacity and collateral either lost or trapped, A.M. Best notes that this has been largely resolved and as a result the weight of freshly raised capital in ILS funds and vehicles could heap further pressure on reinsurers.
Excess capacity pressures are, "Compounded by the continued inflow of alternative capacity that was seen in the fourth quarter of 2017, which has helped offset the collateralized capacity that is currently trapped until losses from 2017 work their way through the settlement process," A.M. Best said.
On a brighter note for reinsurers, A.M. Best does suggest that there could be some stability found in pricing, following the recent major catastrophes.
"Should the frequency and severity of these recent losses help set a floor on catastrophe pricing and alleviate the prolonged erosion in risk returns, it could help stabilize the overall market," the rating agency suggests.
In fact, A.M. Best says that increased demand, such as from government backed risk pools, as well as an improved interest rate environment and more controlled inflation, could all serve to help reinsurers to earn back some of their losses more quickly after the recent catastrophes.
A.M. Best forecasts that, at a minimum, "Underwriting and overall performance will improve slightly and stabilize over the near term, resulting in an average ROE of between 7% and 10% over the cycle."
Will that be sufficient? Certainly not at today's expense ratios and reinsurance firms are going to have to face the reality that they are not the most efficient capital, for certain risks, anymore.
That combined with an increased influence over property catastrophe reinsurance pricing could signal further growth opportunities for the ILS market over the coming years.
A.M. Best says that reinsurance firms ability to earn back their losses will be hindered by inflows of capital and competition from both the traditional and alternative.
Add in the fact that perhaps the most profitable lines of reinsurance business are set to be "at the mercy" of the capital markets and it's no wonder the outlook for reinsurers remains negative.
Continued adjustment to the evolved state of the reinsurance cycle will be required and one likely outcome is a continued and growing use of alternative capital by reinsurers, for underwriting and for hedging.
Alongside this, something is going to have to happen to radically take costs out of the reinsurance transaction itself, to generate greater margins for the underwriters and capital providers. This suggests a continued disruption of the insurance distribution model and the risk to capital value-chain over the next few years.
So, while some reinsurers may have been hoping for a pricing recovery and more stable market, with higher margins and returns, in 2018. It looks more like they will face more of the same, as the disruption of the last 20 years establishes itself as the status quo.
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