15 October 2013

Under pressure

The re/insurance industry is facing pressure on pricing, and Bermuda players may find themselves among the most affected as they might yet have to deal with reserve releases that may decline.

Those are the findings from Standard & Poor’s latest report examining the health of the sector, entitled Pricing, Profitability and Capital Excess. Waqar Rizvi, primary credit analyst at Standard & Poor’s said the sector is facing a unique squeeze: on pricing, from declining reserve releases and from diminished investment returns.

The report found that excess capital was continuing to place downward pressure on pricing, with the influx of convergence capital unlikely to help matters. Rizvi said that at July’s renewals rates were flat to up 10 percent on loss-affected accounts, while those unaffected by loss saw 5 to 25 percent rate reductions.

"A market-wide loss would be needed to change the current course, he said, but a figure that would constitute a market-changing loss appears increasingly elusive."

According to industry reports such players have had to respond with improved terms and multi-year contracts or else draw back capacity. Neither is an attractive option as traditional players seek to find some equilibrium in a new landscape increasingly shaped by convergence capital. The lack of catastrophe losses helped profitability in the sector— particularly among those Bermuda players with a cat focus, the report found—but Rizvi questioned the long-term viability of such earnings performance. He said that while short tail property cat writers (all of which are Bermuda players) achieved strong underwriting results in 2012, with combined ratios of 76 percent; and hybrid reinsurers-insurers (which are nearly all Bermuda players) achieved combined ratios of 94.5 percent, these were largely a result of a benign catastrophe environment, rather than any underlying success in 2012. While loss experience has helped underwriting results, it has also contributed to continuing downward pressure on pricing.

Rizvi stated that Standard & Poor’s believes that “in the absence of a market-wide event that results in significant losses ... the global reinsurance industry will generate lower profitability in the coming years”. Reinsurers will face an increasingly competitive pricing dynamic in the face of record levels of market capital and cat losses that have proved—in recent years—insufficient to bring about any notable turn in the market.

Little cheer

Whereas re/insurers have in the past been able to benefit from prior year releases to strengthen their underwriting results, the report also found that levels of prior year releases are beginning to decline. Rizvi said that this is of particular concern to Bermuda players that “have relied much more heavily on reserve releases for underwriting performance (average impact of 9.3 percentage points) which is partly a reflection of their longer-tailed reserves”.

“This will mean lower prospective margins for the hybrid Bermuda market if recent underwriting years have been reserved at a lower confidence level,” said Rizvi.

Hybrid players have traditionally been “the beneficiaries of the most consistent level of reserve releases”, but it seems that this source of pep to re/insurers’ combined ratios might be lessening. Rizvi said that if the expectations of lower reserve releases materialise, they will require “continued disciplined underwriting” in response, particularly for those hybrid players that have benefited from strong prior year releases.

While 2012 underwriting results may have provided some cheer, the investment environment provided little. Return on equity for the sector “was affected by lower investment yields and was lower than the five-year average for property cat writers (2012: 13.3 percent; fiveyear average: 13.7 percent) and hybrid insurers (2012: 9.1 percent; fiveyear average: 10.4 percent)”. Both groups are dominated by Bermuda re/insurers that—like the wider re/insurance industry—face a tough investment environment.

Standard & Poor’s found that reinsurer investment yield declined to 2.4 percent, down from the five-year average of 3 percent. Rizvi said that this reflected the low interest rate environment as well as moves to shorten asset durations. Bermuda and international players are watching issues such as interest rate risk with interest, with Island re/insurers currently “getting better return than their duration would suggest”, said Rizvi. He warned however that this could be due to them being willing to take on more risk “with regards to the creditworthiness of asset classes in their portfolios”.

A steely focus

Rizvi said that in order to maintain levels of return on revenue in the current “low return environment” re/insurers will need to “focus on disciplined underwriting”. Rizvi said that Standard & Poor’s “estimates that the Bermudan hybrids, property cat players, and European insurers will have to decrease combined ratios by 3 to 4 percent for every 1 percent decrease in investment yield, in order to maintain their 2012 levels of return on revenue”. This will prove particularly difficult in a troubled investment environment and where excess capital and the influx of third party capital have become increasingly prominent features of the underwriting landscape.

The issue is particularly telling for Bermuda companies (both property cat specialists and hybrids), said Rizvi, who indicated that they “face more near-term pressures to increase their underwriting margins”. “This is because they will face the effect of lower reinvestment rates sooner than the European insurers, given their shorter average duration.” Again, Island players find themselves squeezed by market conditions.

Bermuda players do nevertheless continue to lead the market in their return of income, returning “a total of 92.2 percent of their 2012 net income to shareholders, with over two-thirds in form of share buybacks”. This was markedly higher than the global average of 60.2 percent of net income returned, with Bermuda players proving far more aggressive in their share buybacks.

Standard & Poor’s found that the industry continues to be well capitalised, with excess capital remaining flat at $34 billion. While it is likely to exert downward pressure on pricing, the rating agency viewed levels of capital as a “major strength for the ratings on most reinsurers”. Levels of excess capital are strongest among the property cat writers, with Bermuda hybrids also holding strong levels of capital. London Market companies presently operate at the lowest levels of capital at the syndicate level.

Under pressure

Rizvi said that the rating agency believes that ratings “might come under pressure due to prospects of lower profitability”. He added that “while the headline profitability is strong, the sector is facing multiple headwinds from pricing pressure, low interest rates, and a declining level of reserve releases”. However, a market-wide loss would be needed to change the current course, he noted.

The report concluded: “Our benchmarking also highlights that some sectors are more exposed than others to the changing environment. While the property cat writers score better on capital, they face greater risk from declining investment yields (measured by investment leverage) and their ratings could come under pressure under the forecast low interest rate scenario.

“Hybrids, especially those in Bermuda, will face profitability pressures as reserve releases decline, and will have to focus on achieving lower attritional combined ratios, to maintain the same level of profitability.”