Breaking From Other Negative Reviewers,
AM Best Sees Reinsurance Sector as Stable
While other rating agencies continue to rate the global reinsurance market’s outlook as negative, at the end of 2018, AM Best changed its view of the reinsurance market segment to stable from the negative outlook it had held between 2014 and 2018. As Best sees it, there are negative and positive forces in the market that offset each other.
AM Best explained the battling negative and positive forces in its Market Segment Report titled Global Reinsurers Maintain Equilibrium through COVID-19 Turbulence, which was released Sept. 2.
Negative factors include increased uncertainty on claims reserve development associated with previous years’ property catastrophe events; social inflation, and more recently, business interruption and casualty lines related to COVID-19. Combined with an overcapitalized sector, these factors have translated into reinsurance companies struggling to meet their cost of capital.
On the positive side, reinsurance renewals during the first half of 2020 started to show strong momentum, with clear signs of a hardening market. All of which is reinforced by third-party capital providers reassessing their role in the industry after being affected by loss creep, trapped capital and a perceived higher risk as a result of discrepancies between actual and modeled claims experience.
In August, AM Best organized a webinar for a panel of experts to discuss the reinsurance market. Best’s coverage of the panelists’ discussion is five pages of the 89- page Market Segment Report. AM Best’s Meg Green moderated the panel, which featured Carlos Wong-Fupuy, See REINSURANCE Page 6 senior director of Global Reinsurance Ratings,
AM Best; Scott Mangan, associate director, Global Reinsurance, AM Best; Silke Sehm, executive member of the board, Hannover Re, and Jonathan Isherwood, CEO of Reinsurance Americas, Swiss Re.
Wong-Fupuy led off the panel by saying that Best’s stable outlook on the reinsurance segment does not mean nothing changed. To make his point, he described a number of developments, both positive and negative, in the past year.
He attributed Best’s negative outlook between 2014 and 2018 to excess capacity. “Excess capacity from traditional capital and a continued influx from third-party capital providers were pressuring rates,” he said. “The result was soft market conditions, low investment returns and companies struggling to meet their cost of capital.”
According to Wong-Fupuy, AM Best changed the outlook to stable at the end of 2018 because things were stabilizing, albeit at a lower level. “Expectations for return on equity were definitely lower than what historical trends would have suggested,” he said.
Over the past three years, Wong-Fupuy pointed out, claims activity has increased. Natural catastrophes have caused thirdparty capital to look at insurance risks more closely. Their skepticism is not just about losses. Concerns relative to loss creep and trapped capital emerged.
Wong-Fupuy noted that the situation is complicated with COVID-19 increasing the expectation of an improvement in pricing on the one hand, while there is concern about claims on the other hand.
Despite the stable outlook, Wong-Fupuy believes that all companies will not respond the same; their differences will be exacerbated.
Mangan speculated that it could take a while for reinsurers to flush off their balance sheets and take advantage of rising rates. He is not sure that anyone knows what COVID-19 losses will look like, but they could affect companies’ ratings. Market conditions, he said, will affect companies differently, and he’s not sure what rating action will be taken.
Despite the stable outlook, Mangan said, some reinsurers may not be able to weather the conditions because of lagging Enterprise Risk Management practices, business profile, capitalization or operating performance.
Hardening market brings new money Sehm said, “We definitely see capital flowing into the reinsurance space.” She added, “New money has been coming in to start new reinsurance companies.” According to Sehm, the number being mentioned is about $4 billion in comparison to the Bermudan class of new companies after the 2005 hurricanes, which was around $5 billion, and the class of 2001 after the attacks on the World Trade Center, which was $8 billion.
“Clearly, there is a change in rates,” Isherwood said, which accelerated through the first half of the year, from January through June/July renewals and across most lines.
According to Isherwood, there is a lot of capital looking at returns for the last few years that don’t meet expectations. At this time, Mangan opined, specialty and E&S type business seems to have a lot of the momentum going forward.
Wong-Fupuy said that companies need to recover from underperformance, adding that the settlement process for losses is taking longer than expected. Property catastrophe risks have a tail because of loss creep, which affects reinsurers’ ability to swiftly enter and exit the market. Even if there is not a dramatic decline in availability of third-party capital, growth could slow down and investors become more selective.
Isherwood said there has been some retrenchment. Those set up to generate asset returns were not so successful. He pointed out that 2018 was “the worst typhoon year ever,” and it was followed by 2019, which was “even worse.”
Wong-Fupuy said that companies required return has increased and that there are risk tranches in which the return “may not be met.” He observed that new capital is mainly coming from traditional capital providers.
Panelists indicated that escalating reinsurance pricing is not being driven by capital depletion as it was in 2001 and 2005, when capital depletion resulted in widespread market hardening.
Mangan opined that underwriting discipline is the key to this hardening market, in contrast to hard markets in the past. He is not certain that the market hardening is as widespread as it was in 2001, and to some extent, 2005.
He explained that the underlying mechanics of the current hardening market are different. This time around, there is uncertainty relative to COVID-19, and there is uncertainty about the investment environment going forward. Supply and demand issues are not driving the rates up, market uncertainty is.
Previously, there was a capital void; existing market participants were not deploying capital. The difference is that, now, the industry is very well capitalized; to some extent, there is excess capacity in the market.
Are rate increases sustainable?
Sehm believes the rate increases are sustainable for the next two years because of uncertainty regarding COVID-19, which “means a lot of fuel for further rate increases.”
Amid the volatility and uncertainty, Sehm said, highly rated reinsurers have value again. Wong-Fupuy agreed, saying, “There is a flight to quality, so there is value in being highly rated.”
For his part, Isherwood said, “It is a different environment in many different ways. Each marketplace is slightly nuanced. … We’re on the tail end of many years of market softening. That is not just rates, but also terms and conditions.” Isherwood believes there is a “fundamentally different” yield environment, which is the lowest it has ever been. Considering the metrics, he said, “There is no chance to rely on the asset side of the balance sheet over the next few years.”
Interest rates effect on pricing
There was general agreement among the panelists that interest rates have been lower for longer and probably will continue to be low.
Sehm said that low interest rates are only part of reinsurers’ pricing measure. There may be reinsurers trying to mitigate lower return on equity by investing more aggressively, but Hannover Re is prudent and sticks to asset and liability management principles.
In many ways, Isherwood said, the low yield environment could be the longest lasting legacy out of COVID-19. He believes there is not an easy fix on the asset side without significant risk or capital issues. As of 2018, U.S. 10-year yields were close to 3.0 percent and are currently just over 0.5 percent.
Isherwood explained that, on a blended casualty book when comparing the combined ratio to yield, it turns out that it takes a two percent improvement in the combined ratio for a one percent increase in the return on equity.
He mentioned other factors that affect the momentum for casualty rates, including pricing uncertainty, tail volatility and social inflation. In this environment, casualty needs to be priced like a short-tail volatile line. “That’s fundamentally different than in the past.”
From a rating agency perspective, Mangan said, investment risk consumes capital. If a reinsurer is holding capital to support riskier investments, that capital is not available for underwriting without it affecting AM Best’s assessment of balance sheet strength.
Agreeing with Mangan, Wong-Fupuy said it is not all about rates. Reinsurers need to keep an eye on limits and the terms and conditions, which may not have been as tight in previous cycles. He said reinsurers have no option but to pay attention to underwriting.
Reserve releases affect bottom line
Turning the topic to the consistent decline in the benefit of reserve releases, Wong-Fupuy said companies are struggling to meet their cost of capital, and not being able to rely on favorable loss reserve developments just adds to the pressure.
Mangan said that about half of ROE, going back, is attributable to reserve releases. He pointed out that the “low interest rate environment can translate into lower cost of capital, but it is not an offset” for investment returns.
Remarking that reinsurance has been coming off a softening cycle, Isherwood observed that reserving and the yield environment are coming together with other factors, leaving no option but to focus on underwriting.
Aside from underwriting and investment, Mangan said the only “other lever to pull” is on the expense side. “Technology has gone a long way to help in that area,” he said, and it’s probably an area on which, going forward, companies will have to focus “in order to help get those combined ratios to more reasonable levels.”
COVID-19 is uninsurable
The panelists agreed that the nature of a pandemic risk makes it non-insurable. They see the need for some public-private partnership to help economies become more resistant to such risk.
Mangan is “not sure there is the appetite for the industry to underwrite COVID.” He and other panelists agree that the insurance industry cannot diversify away a pandemic risk.
The insurance industry can only play a limited role due to capacity restraints and the systemic nature of the risk, Sehm explained, but Isherwood believes there is a role for the insurance industry to play given its experience in risk management and claims assessment. If government takes the bulk of the risk and reinsurance a small piece, Isherwood said, it could work.
Should a second wave of COVID-19 or other large catastrophe occur, Sehm said “2020 could well become one of the costliest years for the industry. Still, capacity is very strong as the industry entered the pandemic with strong balance sheets, very strong ratings and regulatory regimes … which emphasize risk management and stress testing.”
Calling it a “moving feast,” Isherwood said that it is “hard to speculate,” and capital is not the issue, but flight to quality is.
NOTE: The webinar took place a little over two weeks prior to Hurricane Laura coming ashore in Cameron Parish, Aug. 27 and causing destruction from the Gulf coast through Lake Charles and continuing to north Louisiana as a hurricane.