The major rating agencies covering the reinsurance sector (A.M. Best, S&P, Moody’s, Fitch) have all voiced concerns with the industry’s ability to adjust to the seemingly overwhelming headwinds currently facing the sector. With A.M. Best recently changing its outlook, the view of the reinsurance sector across the rating agencies is now unanimously negative.
There are many common themes, most of them primarily attributable to projected earnings and implications of the current imbalance between reinsurance supply and demand. Specifically, the challenges cited for this negative view include: pressure on overall return expectations from the low investment yield environment and lower re-investment rates, diminishing reserve redundancies, and last but certainly not least, an influx of new underwriting capital from pension funds and private equity investors that is having a softening effect on trading conditions across most lines of business - starting with property rates several years ago - followed by casualty rates more recently. Commentary on reinsurance renewals over the last 18 to 24 months has increased the rating agency concerns on the sector with the headlines citing double digit rate declines, expanded terms and conditions and growth in utilized “alternative” capacity, all of which are expected to continue barring a market dislocation type event.
In effect, the rating agencies are questioning the ability of traditional reinsurance carriers to produce ample returns to justify the cost of capital given the cumulative effect of reinsurance rate declines over multiple years while simultaneously broadening coverage terms. However, the negative outlook of the rating agencies is not merely reflective of current trading conditions and earnings prospects for the next year or two, this negative outlook is also reflective of the longer term implications stemming from the uncertainty associated with the influx of new capital and its questionable long term appetite for “uncorrelated” risk.
Rating agencies are always focused on “managing the cycle” within the evaluation of underwriting performance. How well a management team adjusts to its competitive landscape while balancing both internal and external objectives is a critical component of the rating evaluation. The fact that the reinsurance sector is softening is not unprecedented - reinsurers have dealt with past soft cycles. The difference this time around is the imbalance of reinsurance supply and demand, which is expected to get worse not better. There are several factors driving these changes. The first and most cited by the rating agencies is the influence of new (re)insurance capital providers. This increasing contribution to the reinsurance sector is partially attributed to pension funds that have become more and more comfortable with reinsurance risk in recent years and have the assets to highly influence reinsurance capacity going forward. A small allocation of pension fund assets represents a significant amount of reinsurance capital. The second is the trend of cedents retaining more as many have strong balance sheets that allow for greater risk retention while simultaneously larger buyers are consolidating reinsurance purchases. The third - and likely not a rounding error - is the business that has been taken out of the market through recent mergers and acquisitions transactions or through moving underwriting teams where the new owner retains risk that was previously reinsured in some capacity.
Partially offsetting these headwinds is the growth in the exposure base as mature economies rebound from the financial crisis and emerging markets continue to open and develop. However, the supply/demand imbalance has clearly shifted negotiating leverage to the buyers and clearly evident in recent reinsurance renewals. Managing the cycle will take on a different tone this time around and rating agencies will likely reserve judgment until the effects of recent trends have emerged. Prospectively, rating agencies will likely remain bearish on the reinsurance sector as the pendulum has swung to buyers and underwriting discipline, a hallmark of the sector in recent years, is being called into question. Furthermore, the expectations are the market will continue to be very competitive and reinsurers will be highly challenged to justify their cost of capital. Therefore, it is important to address targeted returns and cost of capital metrics when discussing strategy with the rating agencies. Just as important though, reinsurers should be discussing the relevance of their business model and how they are evolving to compete in a market in which risk is assumed through different forms and channels and some risk is commoditized, packaged and sold to investors. Reinsurers will increasingly need to innovate with new product offerings and services to ensure they can maintain attractive returns and share valuations as new competitors gain comfort with insurance risk.
Guy Carpenter’s Rating Advisory Practice, part of Guy Carpenter Strategic Advisory, is highly experienced in helping clients develop more effective presentations and approaches with their rating agencies and gain better insights on the rating process to achieve optimal rating outcomes. Our best in class team has experience in helping reinsurers prepare for rating agency interactions; supporting the development of effective messaging and analytical support and helping management understand the rating agency perspective to ensure proper meeting preparation. Our team is comprised of highly qualified and experienced staff capable of enhancing management’s understanding of rating agency views and concerns as well as improving communications through our knowledge of the language and perspectives most impactful to rating agency discussions.