Reinsurers’ Profits Risk Falling Below Cost of Capital: S&P

Reinsurers’ profits will soon drop below their cost of capital and could remain there until the underwriting or investment cycle turns, according to Standard & Poor’s in a new report.

S&P attributed this pressure on profitability to a combination of lower investment returns and a continued softening of the underwriting cycle.

Editor’s Note: According to S&P analysts, the cost of capital is the cost of raising additional capital. From a debt perspective, this is easier to quantify as this is the interest rate expected by investors to raise debt. From an equity perspective, this is the (theoretical) return expected by investors in exchange for the risk in investing in a company.

“We currently expect the sector’s return on capital (which was 8.5 percent as at year-end 2015) to drop to around 5.5 percent-7.5 percent as at both year-end 2016 and 2017,” said S&P in its report titled “Reinsurers Approach a Tipping Point as Profitability Threatens to Sustainably Fall Below the Cost of Capital.”

At the end of 2015, the sector’s cost of capital was 6.6 percent and S&P expects this to decline to about 6 percent over 2016 and 2017.

Further, the ratings agency added, the margin for returns over cost of capital has been waning steadily. “At the end of 2015, in a year flattered by benign natural catastrophe experience and significant prior-year releases, the margin stood at only 1.9 percent. It had declined further to about 1.6 percent as of Aug. 1, 2016.”

If the loss experience had been at normal levels and prior-year releases smaller, “the sector in aggregate would not have earned its cost of capital in 2015, or in 2016 year to date.”

“Therefore, even assuming continued favorable prior-year reserve releases and benign natural catastrophe losses, we anticipate that reinsurers will barely cover their cost of capital over the next two years,” S&P said.

It is possible that by the end of 2016, reinsurers’ return on capital will be no higher than 6 percent and flat to their cost of capital, which S&P argued would signal “the start of a truly soft market for reinsurers.”

Returns Still Exceed Cost of Capital

“Despite dwindling returns since 2005, reinsurers have (to date) retained sufficient profitability to satisfy investors because their cost of capital has fallen along with their profitability levels,” S&P said.

“The return investors required in 2005 was also much higher than it is now – today’s investors are operating in an environment in which yields have remained at historical lows for eight years,” the report added.

S&P pointed to the fact that the average return on capital for major banks was 3.4 percent at the end of 2015, while the global industrials sector generated only a 6.5 percent return on capital 2015 (or 200 basis points below that of the reinsurance sector).

Given the lack of asset classes/sectors that offer comparable, or better, yields for investors, S&P predicted that investors will not “cut and run,” even as reinsurers’ profits are put under increasing strain.

A large catastrophe event that causes significant rate hardening may actually lead investors to stay in the sector because of the “sudden pick-up in demand for reinsurance shares. Investors will want to take advantage of those more favorable rate conditions.”

However, as returns on reinsurance securities decline, investors likely will reassess their investments and if they do decide to withdraw their capital, reinsurance rates could harden as excess capital is reduced, S&P affirmed.

Excess Capital Protects Ratings

Despite S&P’s negative stance on the sector’s near-term profitability, it does not expect many ratings actions. As of Aug. 1, 2016, the outlook for 18 of S&P’s 21 non-life reinsurance group was stable. “Of the remaining three groups, the outlook on one (Partner Re) was negative and the outlook on the other two (Lancashire and XL Catlin) was positive.”

S&P said such ratings are based largely on the sector’s excess capital, which acts to buffer reinsurers against the pressures on their earnings.

Protecting Profitability

S&P said all reinsurers are affected by the same pressures on profits, but some reinsurers have more business options. “Reinsurers that have better diversification, by line of business and geography, better lead account capabilities and stronger relationships with cedents will be better positioned in the current climate.”

Such characteristics provide reinsurers with a lower cost of capital and allow them to absorb market pressures for longer, the S&P report added.

“In aggregate, the sector has sufficient excess capital that we expect stronger reinsurers to be able to withstand profitability dropping below their cost of capital for a short while,” S&P said. “Issuer-specific rating actions are thus more likely than sector-wide rating actions.”

Source: Standard & Poor’s