The tailwinds propelling the global reinsurance sector are sufficient impetus for the ratings agency AM Best to retain its stable outlook for the reinsurance industry, despite multiple challenges.

During a virtual press briefing on Sunday, the ratings agency described the headwinds blowing hard against reinsurers.

These headwinds include:

• uncertain COVID-19 effects
• low investment yields and volatile capital markets
• a reduced reserve cushion exacerbated by social inflation and property catastrophe reserve development
• global recessionary pressures
• uncertainty over government actions.

Accelerating Pricing Momentum

“Despite the headwinds and the challenges, we’re maintaining our stable outlook,” said Stefan Holzberger, AM Best’s senior managing director and chief ratings officer. “We feel that COVID-19-related losses will be manageable, and the demand for improved terms and conditions will come through, equating to more exclusions and coverage limitations, in line with the rates being charged.”

“Accelerating pricing momentum at the primary level across many lines of business… will flow through to benefit the reinsurance market,” he said. “We saw that trend in 2019, ahead of COVID-19… It has accelerated in 2020, and we feel that [it] will be continued into 2021.”

Flight to Quality

AM Best also perceives a “flight to quality” among reinsurance buyers. “Top-tier reinsurers are seen as an effective source of capital relief,” Holzberger said. “The top 25 are benefitting from opportunities to grow their top line at better rates than they have seen in many years.”

AM Best expects a revised appetite for reinsurance risk from third-party capital, and greater discipline from traditional reinsurers who are now “more able to set the rates for property catastrophe treaties.”

Holzberger said: “Although a challenging market, where the global reinsurance sector will face difficulties over the near-term, the market is well positioned to handle them, and we are seeing positive trends in some very meaningful aspects.”

“A number of positives and negatives offset each other,” added Carlos Wong-Fupuy, senior director, global reinsurance ratings. He said AM Best changed its sector outlook from negative to stable towards the end of 2018 due to the emergence of a “new normal” as the market got used to lower levels of performance.

This could be seen in 2019 pricing improvements, which were accelerated by COVID-19 during renewals completed in the first half of 2020, especially around Asian and Japanese risks, and in the Florida market, he said. For the same period, underlying attritional loss ratios have improved.

Impact of COVID-19

Reinsurers have reported loss-ratio impacts for COVID-19 ranging from 5 to 20 points, reflecting different business mixes and different reserve approaches. “Companies have been very careful in how they are reserving for COVID-19, and it is still early days,” Wong-Fupuy said. “It is adding uncertainty and pressure.”

“COVID is still ongoing, and a number of issues have not been resolved,” he declared. “Most of the claims are IBNR, so only very rough estimates of how companies may be impacted. In respect of business interruption, after the initial period when most companies were dismissing the impact… We think, for example, the FCA test case [in the UK] opens the field for more questions and challenges.”

Most importantly, he said, the event has challenged assumptions. “Until now, most pandemic modeling was focused on life risks. Nobody predicted widespread government intervention. Another challenge is the correlation with the rest of the economy. Life and non-life [portfolios] seem to have been correlated, and the insurance and reinsurance industry seems correlated with the rest of the economy.”

Reserving Caution

The ability to rely on reserve releases to prop up accident year results has been diminishing over time, Wong-Fupuy observed.

Greg Carter, AM Best’s managing director for EMEA and Asia-Pacific, added: “The amount of reserve releases in recent years has continued to surprise us. It has been a positive impact on the underwriting results, but we’ve questioned how long that could go on for. The well is running dry.” Lower interest rates and the much lower inflationary environment may have fueled the reserve surplus, Carter suggested, but the current depletion of reserves may mean underwriter’s inflation expectations have adapted to the “new normal,” and that “the extra margin in reserves has been competed away over time.”

It is possible that the reinsurance sector may begin reporting reserve deficiencies, Wong-Fupuy said, although in some cases reserves may be more than adequate. “Behind the net numbers, we see different business segments with positives and negatives [affecting their reserving position]. There is still room for reserve strengthening in respect of previous years, since issues related to social inflation are still there.”

But there’s another possibility, he added, because some companies have continued to take a very conservative reserving position. “For example, some companies are thinking that the Japanese typhoons of last year, Hagibis and Faxai, have been over-reserved, and there is probably some fat there.” Whether individual companies feel able to re-reserve at this time is “still an open question,” he said, “but in general companies have tried to be more prudent, and margins are going to tighten.”

Despite volatility in multiple areas, reinsurers achieved a five-year average return on equity of 5.7%, compared to a weighted average cost of capital of 7.5% or 8%. “There is an issue of companies failing to meet their cost of capital, Wong-Fupuy pointed out. “This is nothing new. It has been alleviated to a certain extent in recent times, but I believe it is still an outstanding issue.”

Reinsurers “must try to improve their underwriting discipline. Especially in a low interest rate environment, there is no other source of profits than improved underwriting,” the analyst warned.

How Does This Hard Market Compare to Others?

“The main difference from previous hard markets is that previous hard markets were driven by erosion of capital. In this case there is plenty of capital around, [but a] lack of investment opportunity from certainty,” Wong-Fupuy said, noting that this time around, the drivers of rising rates are “mainly around underperformance.”

How sustainable will the hard market be? “We believe it will need at least a couple of years to compensate for the losses of previous years, and there is still the risk of capital elasticity – pricing and conditions getting to a point where the market gets flooded again – but hopefully that won’t happen any time soon. Only time will tell,” he continued.

What lessons have been learned? “Catastrophe losses do have reserve tails. Trapped capital is an issue which affects ILS markets and conventional markets as well,” Wong-Fupuy affirmed.

Before hurricanes Harvey, Irma, and Maria it was easy to believe in the robustness of cat modelling, but since those storms “a number of factors have emerged around trapped capital and tail reserving… and the correlation between those risks and the rest of the economy. It’s changing perceptions of risk and investor appetite.”

All the factors that are putting pressure on underwriting remain, Wong-Fupuy said.

“We are still in a low interest rate environment. We add recessionary pressures related to COVID, the decline of prior year reserve releases… a reassessment by third-party capital providers, and the added claims uncertainty not just from COVID, but from catastrophe risks which are becoming much more frequent, and social inflation. The nature of risks is changing, and becoming much more difficult to model, to predict, to price.”

*This story ran prevoiusly in our sister publication Insurance Journal.