Another driver of low valuations has been sector book value or capital growth (the denominator in the price-to-book ratio). Figure 1 shows the increase in reported capital since the middle of 2011 for the Guy Carpenter Reinsurance Composite. This growth has been particularly impressive as the sector experienced an exceptional series of costly catastrophe losses during this time. Yet, as the primary sources of capital growth are net income and unrealized gains, it is important to ask: how tangible and sustainable are these sources of growth?
With regard to reported net income, a significant proportion of earnings have come from reserve releases such as those described in the previous section. Given the reserving cycle could enter a new and more challenging phase, it is unlikely that this source of earnings will continue for much longer. Additionally, should net reserve redundancies become deficiencies, capital is likely to come under further pressure.
Likewise, there is uncertainty over the sustainability of the unrealized gains that have elevated capital levels recently due to falling yields on fixed income securities that now dominate investment portfolios. Should interest rates rise unexpectedly for any reason, mark-to-market losses on investment portfolios could materialize just as reserves are becoming more deficient.
Finally, the emergence of new loss potential in non-peak areas poses significant challenges to (re)insurers as they penetrate new markets. The recent spate of expensive cold spot losses has highlighted carriers’ limited understanding of natural catastrophes in non-peak zones, indicating future earnings may become more volatile.