Will investor losses mean a rising tide for pricing?

23-05-2019

Will investor losses mean a rising tide for pricing?

shutterstock / by-sergei-votit

AM Best’s Mariza Costa and Filippo Novella take a look at where the reinsurance market stands as it enters the second quarter.

As 2019 rolls into its second quarter, the reinsurance industry remains uninspiring, in terms of both pricing and profitability.

Most in the industry thought that, once the losses of the last 15 months were tallied, the January 1, 2019, renewals would provide a well-earned respite from insufficient pricing adjustments. But renewal rates instead fell mostly flat, ranging in some cases from up 5 percent to 10 percent and mainly in US property catastrophe (depending on geography and loss experience), which proved a let-down for most.

Companies tried to maintain discipline, with a few walking away from poorly priced business, while others, particularly larger players, continued to focus on market share, willing to write inadequately priced risks.

Given insured catastrophe losses for 2018 in excess of $70 billion, as well as 2017’s ongoing loss creep, reinsurers were expected to react swiftly and adjust their pricing. However, these expectations did not materialise during the January 1 renewal period, which saw mild to nil rate increases on average, with only the third-party-dominated retro space showing a meaningful adjustment.

Disappointing renewal pricing

Whether the impact of past losses will positively influence mid-year renewals remains to be seen, but the January 1 renewals don’t offer much hope. Property programmes affected by losses (including wildfire losses) had the largest pricing increases, as much as 20 percent.

Given the substantial losses of recent years, reinsurers are increasingly recognising the importance of wildfire risk and focusing more on the definition of wildfire occurrence during negotiations.

The January renewal rates were flat to up 10 percent for accounts affected by non-cat losses during 2018. Loss-free programmes have also been flat, with no more than 5 percent rate movements for cat perils, while pricing conditions for non-cat risks have further deteriorated.

Casualty and specialty reinsurance experienced mild price increases; companies understand that rates are at unsustainable levels and that a number of lines need rate increases—such as commercial auto—following multiple years of losses and rate declines.

Pricing in the working layers of the workers’ compensation segment has generally increased by single digits, in response to primary rate declines and a higher frequency of large losses.

The brightest spot for the January 1 renewals was the property cat retrocession segment, which is controlled largely by third-party capital managers, and for which pricing rose between 10 percent and 20 percent, with peaks of 35 percent on loss-affected accounts.

A major contributor to the rise—besides the 2018 cat losses—was the capacity crunch in the collateralised retro space. The crunch was due to investors seeking higher returns and tightening terms, given that their funds remained trapped to cover the development of 2017/2018 losses. The pricing gap between treaty reinsurance and retrocession has further widened, and reinsurers will have to bridge that gap to keep their earnings profile afloat. 

Although January renewals did not proffer the expected price increases following the nearly $200 billion in losses of the past 18 months, the upcoming renewal seasons of April (in Japan) and June/July (in the US—Florida and the Gulf of Mexico) will shed more light on the impact of recent typhoon, hurricane, and wildfire losses on rates for the remainder of 2019.

Despite setbacks, third-party capital remains important

The third-party capital segment has experienced a significant accumulation of losses over the past 18 months and a material portion of fund managers’ assets under management remains trapped in collateral trusts to pay potential losses.

This capital remains influential in the reinsurance segment and, in particular, the property-cat space but for the January 1 renewals most fund managers were not able to replenish above their trapped capital.

Following two straight years of losses, the need to raise rates to garner long-term returns sufficient to satisfy investors is taking on greater importance. In the wake of the California wildfires over the past two years—particularly, the devastating Camp Fire—third-party capital investors have backed away given the unpredictability and difficulty of modelling this risk. The large losses of the past 18 months have driven investors to demand higher returns and made them more cautious.

Third-party investors seem to have become increasingly sceptical following the 2018 cat season, as they have seen their capital trapped for a second consecutive year. For the first time, fund managers are struggling to attract new investors and convince existing ones to reinstate their positions.

Hope for the next renewals?

The steadfast commitment of third-party investors was further highlighted by the growth of capacity in 2018. Working in conjunction with Guy Carpenter, AM Best estimates that the increase in third-party capital from $87 billion in 2017 to approximately $95 billion in 2018 was the principal driver for the 2 percent annual growth in dedicated reinsurance capital.

In contrast, traditional capital is likely to remain flat, owing to underwriting losses and unrealised capital losses incurred mainly in the second half of 2018.

Approximately 20 percent of the 2018 total third-party capital is trapped in the funds and will not be released until insured loss estimates have been finalised. This locking mechanism is a key factor in the assessment of companies’ risk-adjusted capitalisation using our proprietary capital model, Best’s Capital Adequacy Ratio (BCAR).

Depending on the extent and quality of the collateral, the credit risk associated with a certain recoverable position is either partly or fully offset in the calculation, materially benefiting the BCAR scores of re/insurers that purchase third-party capital protection from unrated structures, which would normally attract a 100 percent risk charge.

Therefore, AM Best closely monitors the terms and conditions that regulate the release of the collateral and views favourably any strengthening of terms that diminishes uncertainty over such release.

Overall, the January 1, 2019, renewal pricing was disappointing and far from being a turning point for the reinsurance segment. Additionally, rate increases were often accompanied by a growth in the exposures underwritten, resulting in largely unchanged premium rates on a risk-adjusted basis.

Although the January 2019 renewals may suggest that third-party capital has become more concerned about returns, AM Best believes that investors will continue to invest in third-party capital and that the alignment between third-party and traditional capital will endure, guaranteeing an abundance of capacity for the re/insurance segment.

One main reason is that reinsurance investments constitute a minor portion in the portfolios of institutional investors and pension funds, and therefore do not have a major impact on their overall performance. In addition, investors are especially attracted to reinsurance capital solutions for their minimum correlation with capital markets rather than potential returns.

That said, investors in 2018 experienced losses across all asset classes (except cash), given the collapse of the capital markets toward the end of the year, continued negative development on 2017 events, high losses in 2018, and diminished returns on fixed assets owing to an uptick in interest rates, which led to an increase in realised and unrealised losses.

Still, we believe that 2019 will likely include a decline in the allocation of this type of capital to risk, owing to trapped capital, the hesitation of some to double down, and the possibility that in a rising interest rate environment, investors will be able to find other investments—with more stable returns—in which to invest their capital.

 

Mariza Costa is a senior financial analyst at AM Best. She can be reached at mariza.costa@ambest.com

Filippo Novella is a financial analyst at AM Best. He can be reached at filippo.novella@ambest.com

 

AM Best, investor, losses, pricing, market, capital

Bermuda Re