Weakening Operating Fundamentals Tip Reinsurers’ Outlook to Negative: A.M. Best

August 20, 2014

A.M. Best announced that it has “revised its ratings outlook on the global reinsurance sector to negative from stable, citing the significant ongoing market challenges that will hinder the potential for positive rating outlooks or upgrades, and over time, may result in negative rating pressure.

“This Best’s Briefing, titled ‘Weakening Operating Fundamentals Tip Reinsurance Sector Outlook to Negative,’ states that it has become even more apparent that as compression continues to bear down on investment yields and underwriting margins, the strain on profitability will ultimately place a drag on financial strength.”

A.M. Best first signaled the potential for downgrading the sector’s outlook in an April 4, 2014 special report (Could 2013 Be the Apex of the Next Few Years?), and the rating agency said it has “continued to pore over the metrics for an even better understanding of the market dynamics.”

That review concludes that “It has become even more apparent that as compression continues bearing down on investment yields and underwriting margins, this strain on profitability will ultimately place a drag on financial strength.”

Best explained that this “view is longer term than our typical 12-18 months;” adding that while it “does not anticipate a significant number of negative outlooks or downgrades over the very near term, the market headwinds at this point present significant longer term challenges for the industry.”

Best explained that while there is an “easier path” to justify its action, including “declining rates, the unsustainable flow of net favorable loss reserve development, the low investment yields and the continued pressure of convergence capital, it has “tried to challenge that negative bias and look at a broad range of measures and other trends.

“These include the traditional market’s increased use of capital markets capacity to help optimize results, net probable maximum loss (PML) for peak zones as a percentage of capital, the degree of cycle management and oscillation between primary and reinsurance platforms, the subtle migration into asset classes that will produce some increased yield and the focus on producing fee income.”

The more basic factors, however, cannot be ignored, as “compressed investment yields, lower underwriting margins and broader terms and conditions place a strain on profitability, and that reinsurers are being paid less and less to bear risk.

“Broadly speaking, rated balance sheets are currently well capitalized and capable of withstanding various stress scenarios,” Best’s report said. However, it also indicated that “over time this strength may erode as earnings come under increased pressure and grow more volatile, favorable reserve development wanes and the ability to earn back losses following events is prolonged by the instantaneous inflow of alternative capacity.”

Best cited “all of these issues” as reflecting its “increased concern that underwriting discipline, which until recently had been a hallmark for the reinsurance sector, is beginning to diminish as companies look to protect market share at the expense of profitability.

“Given where rate adequacy is, it will continue to take optimal conditions, including benign or near-benign catastrophe years, a continued flow of net favorable loss reserve development and stable financial markets, to produce even low double-digit returns.

“Such return measures would have been considered average or perhaps mediocre just a few short years ago. In our view, companies with diverse business portfolios, advanced distribution capabilities and broad geographic scope are better positioned to withstand the pressures in this type of operating environment, and have greater ability to target profitable opportunities as they arise. It also places increased emphasis on dynamic capital management in order for companies to manage the underwriting cycle and remain relevant to equity investors.”

Source: A.M. Best

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