David Flandro, Global Head of Business Intelligence
Insurers today are faced with challenges including lower pricing, long-term low interest rates and diminishing reserve redundancies, not to mention increasing natural catastrophe activity in peak risk zones such as Florida. Effective capital allocation and earnings protection are crucial to ensuring profitability and financial flexibility in this environment. The reinsurance purchasing decision is an integral aspect of both risk and capital management. In terms of risk, reinsurance protects insurers against peak or ‘extreme’ events, enabling them to continue providing cover in the wake of disasters. In terms of capital management, reinsurance is an efficient source of contingent capital that allows carriers to enter new business lines, satisfy changing regulatory requirements or simply maintain creditworthiness.
In today’s difficult market, many insurers would be unable to provide continuing cover to businesses, homes and families without the benefit of reinsurance. Reinsurers frequently bear an outsized proportion of losses when they occur. For example, U.S. insured losses from Hurricanes Katrina, Rita and Wilma (KRW) in 2005 amounted to USD64 billion . Of these losses, it is estimated that at least USD30 billion were borne by reinsurers even though the reinsurance sector is roughly one-tenth the size of the insurance sector in terms of premium and dedicated capital. As a result of these kinds of outsized losses, reinsurers tend to experience broad profit fluctuations. This is evidenced by the data in Chart 1, which shows the average historical return on common equity (RoCE) of the Guy Carpenter Bermuda Reinsurance Composite group of companies. Note the recent large losses incurred in years 2001, 2005, and 2008. Although these were followed by periods of above-normal profitability, returns look likely to be lower in 2010 and could deteriorate quickly if losses occur.
Chart 1: Guy Carpenter Bermuda Reinsurance Composite: Annual return on common equity (RoCE) of the average constituent
Source: Guy Carpenter & Company
This trend of healthy profitability during benign periods and large losses following catastrophes is typical for reinsurers. Judging a reinsurer’s profitability only by looking at recent earnings is both insufficient and inaccurate. The true picture can emerge only when returns are viewed over the long-term. For constituents of the Guy Carpenter Bermuda Reinsurance Composite, stockholders’ returns on equity over the last 20 years have averaged 11.7 percent. This represents a return sufficient to continue operating but by no means ‘outsized’. It is notable that during this period, several Bermuda-domiciled reinsurers have been acquired or forced into run-off due in part to large losses.
As a result of the risks inherent to its business, the global reinsurance sector will continue to be carefully regulated. Solvency II regulations, which will be implemented in Europe in 2013, will require particularly conservative levels of capital for non-proportional property reinsurance. Bermuda as a domicile is currently on track to receive “equivalence” with Solvency II prior to the United States, thereby bringing Bermudan reinsurers in-line first with this new global standard. This will mean that certain Bermuda carriers writing property catastrophe reinsurance will need to hold more capital to ensure adequate solvency under the new regime. These new requirements are coming online during a period of weak growth when insurers are retaining more of their premium and demanding lower rates from reinsurers. Furthermore, reinsurers are operating under the same macroeconomic and cyclical conditions as insurers, such as low interest rates and diminishing reserves.
The result? It should be no surprise to learn that the global reinsurance sector trades at twenty year low valuations. Chart 2 shows the price to book ratio of the global reinsurance sector over two decades. These valuations are clearly volatile and affected by cyclical pricing, investment returns, and by the impact of large catastrophes. Given the current operating environment and market conditions, investors appear to believe near-term profitability will be low.
Chart 2: Guy Carpenter Global Reinsurance Composite: Average price to book ratio
Note: “9/11″= Terrorist attacks of September 11, 2001
The picture that emerges is not one of a sector earning excess profits at the expense of its clients. Rather, in spite of its challenges, the reinsurance sector continues to provide a valuable and efficient source of contingent capital and risk mitigation to local and regional carriers. This enables insurers to allocate capital efficiently, and provides them with the capacity to write lines of business they otherwise would not. All of these factors provide benefits to the ultimate client: the homeowner, the business and the individual.
1. Garvin, James R and Joan Lamm-Tenant. 2002. Economic and Financial Perspectives on the Demand for Reinsurance. Rational Reinsurance Buying, Nick Golden, editor (London: Risk Publications).
2. 2010 dollars