Standard & Poor’s Ratings Services announced that it is “maintaining its stable outlook on the global reinsurance sector despite the near-record level of catastrophe losses in 2011,” as it doesn’t expect “a bias in the direction of any rating actions that we may take this year, either up or down.”
While S&P indicated that in the past “many companies could fail to meet our earnings expectations for the year, but, on average, we believe that 2011 should be an earnings event for the sector.” S&P has revised its combined ratio estimate to between 110 and 115 percent for the reinsurance sector, an increase from its previous estimate of between 105 to 110 percent, “due to the losses incurred from the Thai floods in the fourth quarter, as well as loss estimate deterioration on earlier events.”
The rating agency said it believes there “will be clear winners and losers from both an earnings and capital perspective. Some companies will have a marked strategic advantage as they have been able to maintain, or even improve, their capital positions through the year.”
However, S&P also noted that other reinsurers “are currently operating at levels we consider to be deficient for their current ratings.” As a result S&P said it would “continue to review reinsurers for potential negative rating action if we see that they began 2012 with capital positions that are 5 to 10 percent lower than at the beginning of 2011 (or they experience losses outside their stated risk thresholds and appear as a negative outlier to peers). We are currently monitoring companies’ pre-announcements, and will continue to review the sector as companies publish their annual results in the coming weeks.
“Many of the factors that support our views remain the same as last year. We consider that the sector still holds surplus capital, although the amount has fallen from its peak a year ago. In addition, we generally assess reinsurers’ enterprise risk management (ERM) capabilities as strong relative to the rest of the insurance industry.”
S&P pointed out that reinsurers’ ERM “leads the insurance industry, and has helped to keep insurance and investment losses within risk tolerances for the most part. Reinsurers typically focus on investing in high-quality, short-duration liquid assets; we consider that this practice has helped to limit the sector’s exposure to peripheral euro zone sovereign debt.”
Turning to the ever present hard/soft market debate, in S&P’s view “the industry as a whole has experienced insufficient rate increases to declare that we are in a ‘hard market’–characterized by high premium rates and tight terms and conditions.”
S&P also said it considers the “reserve releases that have supported the sector’s earnings in recent years to be unsustainable. Further, earnings over the near term will likely be limited by low interest rates and a relatively weak macroeconomic environment. In our opinion, these factors highlight the importance of disciplined underwriting for the industry going forward and could limit returns in the near term.
“These lower returns, diminishing reserve margins, and the increase in both frequency and severity of catastrophe events have caused the reinsurance sector to trade below book value at 0.9x on average, in our view, and below the historical average of 1.3x, according to Guy Carpenter. We believe that this is likely to restrict the amount of equity that reinsurers would be able to raise after a major capital event.”
Even though “underlying factors remain familiar,” there have been changes in the reinsurance picture around the globe. These “other elements will require monitoring, and could affect our view of the sector going forward,” said the report.
The elements include the fact that a number of regions, generally seen by global reinsurers as being “diversifying risks” or “cold spots” (such as Latin America, Asia, and Oceania) have “experienced an increase in the number of catastrophes and the amount of economic and insured losses.
“For example, Asia and Oceania combined contributed 77 percent of economic losses in 2011, and 61 percent of insurance losses, but these regions only account for about 20 percent of global reinsurance premium. This has brought the value of expanding capacity in these regions into question for many. We understand that some reinsurers are selectively reducing capacity in these markets, while others are tightening terms and conditions and demanding higher minimum rates.”
In addition S&P said it anticipates that some companies” may turn to insurance-linked securitization (ILS) to provide additional solutions for protection in such regions. However, models for these risks are underdeveloped, which we consider a barrier for ILS.
“Pricing changes in the reinsurance market have been fragmented, in our view. Property-catastrophe treaties that were loss free in 2011, and global marine/energy, have experienced rate increases of around 5 to 10 percent. However, loss-affected property-catastrophe treaties experienced greater rate increases although they varied by region. Rate activity on casualty treaties ranged from down 5 percent to up 5 percent and there were no major reductions in capacity.”
In addition S&P indicated that the changes in cat models “have had a more muted effect on pricing than the market expected. Pricing changes were more influenced by changing views on exposure, actual loss experience, and competitiveness of prior years’ pricing. In some lines, we consider the rate increases we have seen to be insufficient to cover increasing loss costs or the increased view of risk. Therefore, we do not consider the market has turned to ‘hard’ across the board yet.
“The cost of traditional reinsurance has neither spiked, nor shown signs of a prolonged rise. This supports our view that convergence between ILS and traditional reinsurance pricing is not likely in the coming years, and that ILS will remain a complementary product to reinsurance.”
However, S&P did point to an increased interest in ILS in the second half of 2011, with several deals to come to market in the first quarter of 2012. The report cited two factors which combined to increase interest in ILS:
• Insurers looking for additional capacity during the second half of 2011 and into 2012, following the loss events of last year.
• Insurers seeking to benefit from multiyear coverage at a fixed price, especially for aggregate structures.
In addition, S&P noted that there is “strong investor interest in ILS,” which is perhaps a reaction to the “depressed valuations we are seeing for traditional reinsurance companies, which are currently trading below book, and below historical averages.
“After a major capital event for the market, we anticipate that ILS solutions will compete with recapitalizations of existing reinsurers. These solutions include catastrophe bonds, industry-loss warranties, and sidecars” – the special-purpose vehicles reinsurers establish to provide underwriting capacity to a specific reinsurer. “We anticipate that reinsurers will choose to form new ILS entities because of their ease of establishment, defined investment period, and prescriptive risk selection.”
In the future S&P said it anticipates that there will be “clear winners and losers emerging from the current market conditions. While, in our view, the sector as a whole has excess capital, individual companies vary widely in their capital levels. Some operate with capital at or below their rating level.
“We anticipate that certain reinsurers with strong capital positions stand to benefit greatly. This is particularly the case for reinsurers that also have strategic risk assessment capabilities strong enough to enable them to capitalize on the regions that are seeing rate increases while also managing the downside in other markets. Other reinsurers may struggle to defend their competitive positions and profitability as they face higher modeled loss exposures, lower available capital, and restricted financial flexibility.
“For the sector as a whole, we do not anticipate a bias in the direction of our rating actions over the coming year, either up or down. However, should the industry fail to generate sufficient profitability to maintain its balance sheet strength, or should we see a major shock to industry capital (for example, another large catastrophe loss or major adverse reserve development on long-tail lines of business) we could revise our view of the outlook on the sector.”
Source: Standard & Poor’s
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