Six months into 2014, bond credit rating agency, Moody’s Investor Services published its industry outlook for reinsurance. In the report, the company downgraded its global reinsurance outlook from stable to negative. An industry that started the year unde
According to Kevin Lee, senior credit officer at Moody’s, the company’s change in outlook midway through the year, was prompted by a number of factors that are expected to put increased stress on reinsurers in the coming 12 to 18 months. While many of these influences have been developing over the course of recent years, Lee indicates that the industry is now reaching a turning point. The influx of alternative reinsurance vehicles in the form of insurance- linked securities and traditional catastrophe bonds is of particular concern to the entire reinsurance market in the developed world. “Traditionally reinsurers have relied on their catastrophe lines to cross- subsidise their other, less profitable lines. A smaller cat market will mean that reinsurers need to start looking at other means of supporting these lines,” Lee says. The effect on developing markets is much the same as the supply of reinsurance capacity entering the developed world, and as a result, begins to outstrip demand. According to Lee, the softening global market for reinsurance shows similarities to the state of the market around twenty years ago. Barring a major event like the September 11 attacks, this could indicate difficult times ahead for reinsurers.
Lee notes that the current reinsurance market cycle bears a striking resemblance to the state of the industry in the late 1990’ s. “There is an overabundance of supply at the moment. We have traditional reinsurance offerings competing with several alternative vehicles such as insurance- linked securities. Pricing has declined noticeably year on year and the power of buyers to bargain for reduced pricing, has grown,” Lee says. The conditions may be similar but, according to Lee, the drivers behind these similarities are quite different from the ones in the past. Previously high interest rates and a strong stock market resulted in loose underwriting by insurers. Less stringent constraints on insurers also allowed for more aggressive underwriting leverage. Today’s conditions are the exact opposite but the result is the same. More stringent legislation around insurance has resulted in much more careful underwriting and the depressed stock market has motivated insurers to seek methods of reducing their reinsurance spend.
Tipping the scales
Lee states that there are a number of factors that can swing the outlook for the reinsurance market in either direction. However, even if some of these swing factors occur, they could still push the reinsurance market in either direction. Lee tells RISKSA that the drastic price decrease in reinsurance products over recent years is expected to slow significantly. However, a further 15 to 20 per cent drop in catastrophe prices over the next year is not an impossible scenario. This would bring prices down to below 2001 levels and some reinsurers may need to revamp their capital structures if they want to continue earning their cost of capital. Secondly, a rise in interest rates would provide more clarity on how much of the non- traditional capital that has flowed into the market will have any staying power. “Our working assumption is that many of these investors are equally motivated by diversification and therefore would likely stay when interest rates rise. Higher interest rates would boost reinsurers’ investment income, which would be credit positive, but
“With buyers bundling higher volumes of risks in their reinsurance programmes and consolidating panels, reinsurers that can provide substantial capacity have an advantage over small reinsurers”
may also encourage some reinsurers to sell products at below cost to hang onto market share,” Lee reports. One factor that could shift the market into a hardening cycle is a sizeable catastrophe event. According to Lee a major loss, particularly in Florida could scare off some non- traditional capital, especially if the loss undermines confidence in the cat models. The opposite may also occur and the prospect of higher prices could trigger an inflow of new money “Our working assumption is that many investors would not walk away after one bad year given the good historical performance of cat bonds and ILS funds. ILS funds are coming off their fourth best year since 2006, having delivered a 7.67 per cent return last year, net of fees, according to the Eurekahedge/ ILS Advisers Index,” Lee states A large catastrophe event would test the ability and willingness of non- traditional providers to honour their obligations in a manner that meets buyers’ expectations. A large loss would also test their contract provisions, including collateral release mechanisms. Such a test could either legitimise non- traditional capacity as a reliable counterparty or raise doubts about its value proposition.
The year to come
In spite of the negative rating, Lee says that the reinsurance may well see some limited positive upswing in the coming year. “It is unlikely that we will see reinsurers going under in the coming year, but we could see a noticeable reduction in the capacity of many,” Lee says. Lee believes that the reinsurers who will best be able to cope with these challenges of the coming 18 months will have a number of traits. Firstly, relevant size will be an important factor. “With buyers bundling higher volumes of risks in their reinsurance programmes and consolidating panels, reinsurers that can provide substantial capacity have an advantage over small reinsurers. Going forward, a reinsurer may need at least US$ 3- 4 billion of capital ( including the capital it manages via sidecars and other investment vehicles) to be viewed by buyers and brokers as long- term strategic partners,” Lee states in his report. Reinsurers with proven track records, having already paid their dues with clients are also better placed. According to Lee, current market conditions favour reinsurers that have already established themselves as strategic partners with clients and demonstrated their value through additional services like data quality assessments and model teardowns.
Similarly, reinsurers with a track record of paying claims promptly, managing collateral release mechanisms fairly, providing cash advances to clients voluntarily, and resolving coverage issues reasonably are more likely to differentiate themselves from non- traditional capital providers. The growing trend among insurers is to reduce their reinsurance spend by consolidating lines or bundling their insurance risks. Reinsurers that have expertise in multiple products and multiple geographies have a better chance of differentiating themselves from competitors with more limited product sets. Similarly, this flexibility will also set the reinsurers apart from non- traditional service providers.
Junior Ngulube, CEO of Munich Re of Africa tells RISKSA that the year has so far gone according to the company’s expectations. “It is quite early to comment but so far we have been making some good strides in reaching the goals we set out at the start of this year,” he starts. In January of this year, Ngulube explained to RISKSA that Munich Re of Africa would take measures to make up for the anaemic performance of the previous year. Among these was a renewed focus on infrastructure projects on the African continent. “So far we’ve seen a lot of movement on transport and power infrastructure projects, and we are quite optimistic about development in Africa,” he says. “We also see quite a few insurers working to reduce some of their reinsurance spend but it is to be expected in a market that is making efforts to become more efficient. As reinsurers we should adapt to support this market,” he adds. As far as the movement of reinsurance capacity into the developing market of Africa goes, Ngulube tells RISKSA that change is still slow. “Even though booming economies like Nigeria and Kenya do offer new opportunities, South Africa remains the largest market for both insurance and reinsurance. This probably will not change very soon,” he states. Extreme weather events like the ones that hit Gauteng at the end of last year are still in the back of everyone’s mind, and Ngulube says that the industry should expect more to come. The rest of 2014 has been relatively quiet however. “The year isn’t over and we can still see some serious weather later on,” he adds. Ngulube admits that the market is still some way away from making a full recovery but he adds that Munich Re of Africa remains optimistic about what the rest of 2014 will bring for the company.