Almost half of the global reinsurers rated by Standard & Poor’s are “materially exposed” to competitive pressures, the rating agency said Monday, warning of negative rating actions to come for some.

Although reinsurers have given “lip service” to expanding into developing markets and there’s even talk of broker-led reinsurance facilities forming to help smaller reinsurers hang onto reinsurance customers, supply-demand dynamics clearly favor primary carriers over reinsurers generally, S&P says.

The report highlights record-high capital levels within the global reinsurance sector and the continued inflow of alternative capital on the supply side. Buyer activities to streamline reinsurance programs and reduce the number of reinsurers are impacting the demand side.

The resulting “increasingly competitive behavior” between reinsurers during Jan. 1 renewals was the “tipping point” that signaled a negative trend in financial strength ratings for the reinsurance sector to S&P analysts.

“In our opinion, these competition-related risks have become the most prominent threat to the sector,” exceeding macroeconomic risks that also threaten it, S&P says.

S&P believes the high degree of competition—so far evident in lower reinsurance prices only, not yet relaxed terms and conditions—will weaken reinsurer profits in 2014 and 2015. Indeed, while estimating a sector combined ratio under 90 for 2013, S&P forecasts something in the range of 95-100 for 2014 and in the 98-104 range for 2015.

With operating earnings set to decline prospectively, S&P moved to a negative forecast after eight consecutive years of stable outlooks for the global reinsurance sector. In contrast, rating agency A.M. Best, which sees similar competitive pressures and profit dips ahead, is maintaining a stable outlook for the global reinsurance sector over the next 12-18 months.

In a Jan. 2 briefing, Best said reinsurer operating results and total returns on equity “will be squeezed as underwriting margins are pressured by increased competition and [by] low investment yields,” noting that reinsurers are expected to produce returns in the high single-digit range.

Although that is lower than the double-digit returns that Best talked about in its January 2013 outlook report, continued discipline on the underwriting and investment sides is keeping the stable outlook intact along with other factors, Best says.

“If we continue to see deterioration in the pricing, then that would be a turn for the outlook. It would be reflective of the pressure that the new capital and the new money coming in the market would be placing on the industry,” Matthew Mosher, senior vice president of rating operations at A.M. Best Company, told Carrier Management during an interview at the Property/Casualty Insurance Joint Industry Forum in New York earlier this month.

For now, however, “what we’ve seen is good risk management and well‑managed companies that maintain a disciplined pricing level,” Mosher said. And while ROEs are lower, they have “maintained a reasonable ROE that met expectations overall—that companies found acceptable.”

S&P has a different view of a similar picture. “We believe that recent talk of looser terms and conditions could spell the beginning of a shift away from the sense of reinsure unity in underwriting discipline that we have perceived in recent years,” S&P analysts write in their report.

Changing Sector Dynamics

S&P does note that despite all the “talk” in the market, reinsurers appear to have maintained their stance on current terms and condition at Jan. 1 renewals, even as prices dropped “in almost all global lines of business.”

Still, the report says the following supply dynamics are causing concern:

• Shareholders equity in the reinsurance sector grew by an estimated 10-15 percent in 2013, while estimated premium growth was 5-8 percent.
• Alternative capital is having “a spill-over” effect on pricing in markets outside the United States.
• Reinsurers who have talked about putting excess capital to work in developing markets have been stymied as they faced lagging insurance penetration, volatile economies and poor profit prospects.

On the demand side, as buyers seek more tailored reinsurance coverage solutions, “a divide” is emerging—with large, experienced players benefiting.

“Those on the wrong side of the divide are searching for ways to remain relevant,” S&P says, reporting a market rumor about the development of broker-led facility to help in this effort. According to S&P, with broker-led facilities coming back in vogue over the past nine months, “there has been talk of consortia being formed to counteract larger reinsurers’ efforts to exploit their direct relationships with cedents.”

For some reinsurers, “consolidation may be one of the few viable survival options,” S&P also says in its report.

Prospective Assessment

Others could suffer negative S&P rating actions.

“As we enter 2014, the changing reinsurance marketplace is manifesting itself in stunted profitability. We think that companies without a defendable competitive position or those who are more aggressive in maintaining market share by competing on price or relaxing their underwriting discipline, are most at risk,” the report says.

While stating that “nearly half” of the 23 reinsurance groups that S&P rates are significantly exposed to competitive pressures, the report does not specifically identify which of the four property-catastrophe reinsurers, six large global reinsurers, and 13 hybrid insurers/reinsurers might not have “defendable” competitive positions.

One hint—”Smaller, catastrophe-heavy reinsurers are most under pressure, in our view,” the report says.

“If we observe that a reinsurer’s product mix or risk profile indicates unfavorable competitive undercurrents, relative to other global reinsurers, we could revise our assessment of its business risk profile to reflect the relatively higher risk,” the report also says.

The “business risk profile,” or BRP, is one of two main components of a new rating model that S&P introduced in May last year. The BRP combines an assessment of the overall industry and country risk with an assessment of the insurer’s competitive position.

Financial risk profile, FRP, is the other component, which includes prospective assessments of capital and earnings.

In a blog post commenting on S&P’s report, Stuart Shipperlee, Analytical Partner for Litmus Analytics in London, takes some guesses about the potential downgrades.

“Counterintuitive though it might seem at first sight, those…with ‘only’ a strong competitive position assessment might seem exposed,” he writes, also noting that one other reinsurer, Maiden Re, has only an “adequate” competitive assessment from S&P.

Shipperlee also notes that the reinsurer potential downgrades that S&P is signaling in its report could be controversial—more controversial than previous reinsurer downgrades, such as those of Converium and Gerling in past years.

“This time, S&P is indicating the risk of downgrades driven simply by its view of a reinsurer’s prospective earnings,” he says. “It is one thing to issue a downgrade based on a balance sheet event such as a severe [catastrophe] loss, asset write-down or reserve hike; quite another when it’s based on the agency’s judgment about weakening earnings potential,” he writes.

Shipperlee underscores the fact that “prospectiveness” is the prime focus of S&P’s revised rating criteria. “A fundamental plank of that is how the relative strength of a reinsurer’s ‘competitive position’ supports sustainably strong earnings and it is this—directly or indirectly—that S&P highlights as the likely source of [reinsurer] downgrades” now, he explains.

Alternative Capital: Where is All This Heading?

Beyond sounding the alarm about possible downgrades, S&P’s report contains another warning—this one about the impact on nontraditional capital providers. In particular, the report notes that an influx of capital to the catastrophe retrocession market has driven price declines that are outpacing those in the traditional catastrophe reinsurance market.

“While this will provide some short-term relief as the reduction in cost will partially offset the reduction in income for reinsurers, we believe there will be a temptation for reinsurers to take advantage of arbitrage opportunities and over-rely on retrocession to manage exposures.”

“It’s not beyond the realms of possibility that a reinsurer could effectively become a conduit for passing risk from the insurance market to the retrocession market. In our view, this would significantly undermine a reinsurer’s competitive position,” the report warns.

More broadly, speakers at the Joint Industry Forum addressed the question of where alternative capital is headed outside of the catastrophe reinsurance and retrocession markets. Will it move into casualty reinsurance or the commercial insurance space?

“Long term, I think it is something that’s going to move further and further as the investment markets get more comfortable with the modeling of liability risk,” A.M. Best’s Mosher told Carrier Management. “You’ll start to see a change in the dynamics,” he said, noting that when he talks to young people who are getting into the insurance industry, he describes a future in which companies will be underwriting experts and “aggregators of risks,” which are simply “pushed out to the capital markets through insurance‑linked securities.”

“Ten, 20 years down the road, it’s going to be a major part of the insurance industry,” he predicts.

Speaking during a panel discussion at the Forum, Mosher repeated his prediction. For insurers and reinsurers, “the real question is going to be are you a strong underwriting shop that is going to attract capital to support your underwriting?”

“It goes back to the old Lloyd’s days of capital backing a good group of underwriters,” he said, describing what he viewed as a “back to the future” scenario.