Global reinsurance sector profits in 2016 will fall below 2015 levels as soft market rates, low investment income and an over-supply of capital continue to take their toll on the market, according to a new report from Fitch Ratings.

Fitch forecasts that the underlying accident-year combined ratio excluding catastrophes will deteriorate in 2016 as underwriting margins weaken from premium rate pressures, although rate declines will continue to moderate.

“Profit levels will decrease in 2016 across the global reinsurance sector; however, capitalization is expected to remain strong as reinsurers actively manage capital for current market conditions,” said Brian Schneider, senior director at Fitch.

In its report titled “Global Reinsurers’ 2015 Results and 2016 Forecast,” Fitch said the reinsurance sector’s overall calendar-year combined ratio likely will deteriorate to 96.9 percent in 2016 from 86.6 percent actual in 2015.

One reason for the expected deterioration, the report indicated, is that catastrophe losses will – sooner or later – return to the long-term historical average (1995-2015) of about 10 points on the reinsurance combined ratio from only 2.7 points in 2015.

If catastrophe losses return to normal levels, Fitch expects the reinsurance sector “to manage capital prudently while maintaining overall capital strength.”

However, with the dearth of large catastrophes and deterioration in market fundamentals, Fitch said, there is a “greater chance that any individual reinsurer may have picked up unintended aggregations to retain shrinking business that will only manifest when a sizeable catastrophe event occurs.”

Reserve Releases

When losses return to form, reinsurers will no longer be able to rely on prior-accident-year reserve releases, the report suggested. Indeed, Fitch said, 2015 marked the 10^th consecutive year of overall reserve releases, driven by benign loss cost trends.

“Most reinsurers are reporting a mid-single-digit percentage-point benefit on the combined ratio, with several recording a double-digit favorable impact,” the report said. “In 2015, all reinsurers posted favorable reserve development, with the total down slightly from a year earlier, although almost half of companies reported somewhat higher levels in 2015.”

Such favorable reserve development will continue to steadily decline, as it has done since 2010, which will add pressure to run-rate profitability, the report said.

“However, development should remain favorable overall at 2 percent-4 percent of net earned premiums in 2016/2017 as reinsurers have maintained conservative reserving practices,” Fitch continued.

At the same time, return on equity (ROE) is projected to decline to 8.1 percent in 2016 from 9.9 percent in 2015, with both underwriting and investment results under pressure, the report continued.

“In the absence of a major loss event, opportunities to deploy capital profitably will continue to diminish, leading reinsurers to return earnings to shareholders through share repurchases and special dividends,” Fitch said.

Fitch expects only slight annual shareholders’ equity growth in 2016, following an overall decline in 2015 due to the U.S. dollar appreciating over foreign currencies.

While Fitch’s fundamental outlook for the reinsurance sector has been negative since January 2014, the ratings agency says it maintains a stable rating outlook as most reinsurers will maintain profitability and balance sheet strength over the next 12-18 months.

M&A Activity

“Industry consolidation is likely to continue in 2016 as reinsurers look for scale to improve profitability; however, Fitch would negatively view any individual deal that is driven solely to achieve greater scale and diversity without a clear strategic rationale,” added Schneider.

Fitch noted, however, that near-term M&A deals may not match recent levels, given the reduced number of companies currently looking to consolidate following recent transaction activity.

“In addition, the price required to get deals done has climbed, with several re/insurance transactions pricing near and above 2x book value, primarily driven by buyers looking to diversify and grow outside of their home region,” the report said.

“Fitch maintains a cautious view on M&A due to execution and integration risk, but views a certain amount of sector consolidation positively,” the ratings agency said, predicting that over the long-term, the global reinsurance market will have fewer, larger-sized players.

“Though market consolidation may benefit the newly created, larger, more diversified reinsurers, Fitch believes that it will become increasingly difficult for the segment to generate adequate returns on capital due to the lack of a catalyst for a reversal in the softening rate environment,” the report noted.

Source: Fitch Ratings