Signalling from reinsurance CEOs around the 2017 earnings announcements has been more bullish about the outlook for their industry than in previous years, citing increasing interest rates and a hardening market. But is this optimism merely panglossian naivety? And if not, how might the reinsurance industry feasibly improve its results?
Why you should take the good news with a pinch of salt
- It’s worth remembering that CEOs are always under pressure to put a positive spin on the situation: therefore good results are a sign of sustainable growth, and poor results are turning the company in to a lean fighting machine looking forward to sunny uplands just around the corner. Fundamentally CEOs are judged (and remunerated) by share price growth so they will always try to talk a good game at this time of year.
- Although the trend of declining rates for the last few years was halted at 1/1 (when most reinsurance treaties incept for the year), ‘needle moving’ increases of 10%+ were limited to loss affected lines (and some California Earthquake following a revision in RMS’s model). The market wide increase of 0-5% seems pretty small given that global property cat rates were 30% higher five years ago, according to JLT Re. The caveat to this is that more loss affected lines will renew later in the year.
- Reinsurance can be distilled down to a ‘supply and demand of capital’ equation: when reinsurers have built up excess capital because they don’t experience a loss (and if interest rates are low- pushing down the price of capital) then reinsurance premiums will go down. The HIM losses last year were an earnings event but they were not a capital event for the industry: many reinsurers still achieved a profit for the year. Reinsurers are still swimming in capital with investors ready to replenish any that may be lost (see chart attached, data from JLT Re).
Why the prognosis is poor
- Historically the cash cow for reinsurance has been property cat treaties, especially American east coast (i.e. hurricane damage in Florida/NY), which has effectively subsidised the other lines of business. However, the ability to model the cost of damage from different windspeeds and predict the likelihood of hurricanes occurring by companies like RMS and AIR has increased the use of insurance linked securities (think of a pension fund stumping up a big pot of cash which they charge an insurance company interest on. If a Category 5 hits Sunset Boulevard Miami then the insurer keeps the pot of cash in order to pay its claims).
- Pension funds don’t need to subsidise other lines of business, are so big they can take more risk on this investment, and like the fact that the stock market doesn’t correlate to windspeeds, so are happy to charge much lower rates than reinsurers for this business. This has put a ceiling on the amount that reinsurers can charge for some of their most profitable lines of business.
- It is possible this ceiling is higher than property cat rates are currently, but it is unlikely rates will ever return to previous heights seen in the immediate aftermath of Hurricanes Andrew and Katrina. This is the new normal.
Where is the upside
- Reinsurers are able to smooth their results by re-estimating their reserve levels (within their accounting rules) – this allows them to build up excess reserves when times are good, and release them when the market cycle changes. The soft market for reinsurance has continued for such a period of time now that the industry has run out of these excess reserves. This may mean reinsurers make greater losses from catastrophes in 2018, but may also be the change in the tide that the market is after.
- Ultimately reinsurance has advantages that insurance linked securities won’t be able to match – e.g. a catastrophe bond linked to windspeeds or even to industry wide losses may not exactly indemnify a particular insurer for the losses that it incurs from a hurricane - so there will always be a demand for the reinsurance core product.
- Reinsurers are finding other ways of making money – rebranding themselves as a one stop shop for insurance CFOs: providing an ecosystem of risk and capital management solutions, and offering themselves as more of a consultant (their breadth means they see more of the insurance industry than most insurers/brokers and have access to reams of data, and their scale means they have the money to invest in new tech solutions they can share with clients).
- Longer tail lines like life and motor benefit from increased interest rates as reinsurers often use the premiums to invest in fixed income before they pay the claims. Higher interest rates mean better investment returns. They also make capital more expensive, which impacts the supply and demand equation mentioned earlier.
What does that mean for 2018
Only with the passage of time will we know whether reinsurers’ optimism is justified, but there are some developments we can be more confident of seeing in the year ahead:
- Reinsurers are looking to grow the services they offer customers (selling underwriting applications, natural hazard information, simulators and on). Munich Re Digital Partners – an accelerator for aspiring insuretech start ups – gives it an insight in to the likely disruptors of the future, while Swiss Re’s new “Solutions” offering is built upon sharing information with clients (topics include internet of things, telematics, liability accumulation etc.) in order to receive a differentiated share or price.
- Reinsurers are branching out beyond traditional brokers as a distribution channel. The biggest players have been directly approaching clients offering ‘bespoke’ reinsurance for several years. Tier 2 reinsurers may increasingly get in on this act while Tier 1 reinsurers develop their engagement with investment banks… and even accountancy firms!
- We can expect more M&A in 2018 as reinsurers look for things to do with their excess capital, and big is beautiful in reinsurance.
Source: JLT Re