Martyn Street
Reinsurers are maintaining financial strength but face structural market change, warns Fitch Ratings in its 2016 Global Reinsurance report
By James Brewer
Absence of large losses for several years, intense market competition and sluggish demand from reinsurance buyers have resulted in a softening market for reinsurers, ratings agency Fitch has said in its 2016 Global Reinsurance Outlook, one of a collection of reports grouped under its Global Reinsurance Guide.
Martyn Street, a senior director at Fitch, and Chris Waterman, managing director, emphasised during a press conference in London that the market was going through structural, and not just cyclical, change.
First-half 2015 insured natural catastrophe losses globally totalled (according to Munich Re’s NatCatService) $12bn, far below the $31bn in first-half 2014 and $39bn in first-half 2013.
The market is characterised by falling prices and, less visibly, by weakening terms and conditions, the ratings agency said.
The report details three key issues that are expected to pose a challenge to reinsurers during 2015:
* Deterioration of pricing adequacy and terms and conditions;
* The search for higher yields increases risk as low investment returns persist;
* Structural change threatens to weaken the competitive position of traditional reinsurers.
These factors lay behind the negative outlook maintained by Fitch for the global reinsurance sector.
Fitch sees the prevailing adverse conditions in the reinsurance market as extending beyond a normal cycle. It sees the big ‘Tier One’ reinsurers – including the four major European companies, Munich Re, Swiss Re, Hannover Re and SCOR – as being among sector winners as the landscape reshapes.
The decline of premium rates has been exacerbated by the growth of alternative capital, said Mr Street.
Alternative forms of capital comprised 18% of the entire global property catastrophe reinsurance limit in 2014, up from 16% the previous year. In 2014 some 45% of this alternative capacity was collateralised reinsurance, 40% was catastrophe bonds, and 15% industry loss warrants and ‘sidecar’ operations. High yields had attracted organisations that had traditionally invested in other sectors of the economy, said Mr Street. Private equity and pension funds would continue to be attracted. “This is a permanent change that needs to be adapted to” by the industry, he remarked.
Chris Waterman
On the impact of the continued convergence of the traditional and alternative reinsurance markets, the report said: “The growth of alternative capital is viewed as a credit negative for traditional reinsurers’ ratings, as a significant portion of capital-market funds is expected to remain permanent. Thus, Fitch views the current soft market as not just a normal cycle.”
The high level of surplus capital held by reinsurers leads Fitch to expect that soft market conditions would continue, although the rate and extent of further price deterioration is unclear, said the agency’s analysts.
Primary insurance companies are increasingly centralising their reinsurance buying and this ultimately reduces the demand overall for reinsurance, Mr Street said. The emergence of global brokers too tends to favour larger players, and would squeeze some of the more marginal operators.
Mergers and acquisitions activity heated up in the first half of 2015, and more could be ahead, but this could lead to complacency, warned Mr Street. Fitch had believed there needed to be a certain amount of consolidation but it remained unclear over the longer term what value ome deals would bring to shareholders or cedents.
Fitch Ratings’ fundamental outlook for the reinsurance sector is negative, and the softening market together with the onslaught of alternative capital “leads us to expect that prices will continue to fall, and for terms and conditions to weaken into 2016 across a wider range of business lines.” The agency initially moved to a negative global reinsurance sector outlook in January 2014.
Despite the growing headwinds for its rated reinsurers, Fitch maintains a stable rating outlook for this group in aggregate. This assumes a base case scenario that over the next 12 to 18 months a majority of reinsurers will be able to maintain adequate profitability and strong capitalisation despite softening prices, and that any declines in earnings will be within ranges that current ratings can tolerate.
While ratings for most reinsurers are expected to be unchanged, there is heightened risk that some smaller mono-line companies, especially those with property catastrophe books, where the pricing fall has been concentrated, could suffer downgrades or be moved to negative outlooks.
“We are at a point where discipline remains in the market, ” said Mr Street. “If we see disorder in the market in the next 12 months, that could result in a number of negative [rating] actions on some companies.” Fitch was watching in particular the January 2016 renewals for any step back from discipline.
The persistence of low investment yields increased the risk of adverse investor behaviour, as both reinsurers and investors sought higher returns. There was significant variation in return on equity: Hannover Re at 16% and Swiss Re at nearly 14% had achieved strong results; Lloyd’s was at the recent year global average of 10%; but 16 other leading businesses, including Munich Re, were below 10%.
Fitch said it would change its general rating outlook to negative if combined ratios were expected to hover closer to 100% (the 2015 forecast is 95.7%) or return on equity dropped below 10% (in 2015 it was seen as being 11.1%), even if capital remained strong. Such a move could equally be triggered by a catastrophic loss event of $70bn or more, coupled with significant unrealised investment losses from an abrupt jump in interest rates of 300 basis points or more
Fitch’s recently upgraded reinsurers include Hannover Re, Lloyd’s and XL, with Swiss Re, SCOR and Arch Capital currently on a positive outlook.
Fitch expects most reinsurers will maintain both profitability and balance sheet strength over the next 12 to 18 months commensurate with current ratings. It said that there is an increasing risk, however, that some smaller reinsurers, especially those with more heavily exposed property books, could experience downgrades or movements to negative outlooks.
