While no one directly asked the question of this article’s headline at the S&P Global Ratings June annual insurance conference, the prospect that an outlook change is near came into view during the industry meeting.
During a panel on property/casualty sector trends moderated by John Iten, senior director and P/C Insurance Sector Lead, Iten asked Associate Director Saurabh Khasnis to explain why S&P has a negative outlook on the global reinsurance—a stance that the rating agency has maintained since May 2020.
“Although we have our view on the sector as negative, we think that the tipping point is coming sooner for a more stable view,” Khasnis said. “We could revise our view on the sector if the reinsurers maintain discipline in pricing and underwriting,” he added, after explaining that a key reason for the negative outlook was the downward pressure that catastrophe losses have had on earnings and the failure of reinsurers to boost contract prices enough to overcome that impact until recently.
“The industry’s profitability has been below par for the last several years,” he said, noting that losses from the pandemic, Russia-Ukraine loss exposure, loss creep and volatile investment returns all contributed to the fact that reinsurers “failed to earn their cost of capital in five out of the last six years.”
“But the key reason behind the [poor] performance is the natural catastrophe losses,” he told analysts and executives attending the conference. “I’m stressing the catastrophe losses because of impact [they] had on the earnings not just for one or two years. We have seen that for the past six years,” he said, reporting that catastrophe losses have been nearly three percentage points above their reinsurers’ cat budgets in each of those years.
In other words, “if the cat losses would have remained within the budgets, reinsurers’ ROEs could have been 2-3 percentage points higher.”
“Reinsurers have taken rate actions. They have been getting rate increases since 2018 but the real question here is about the rate adequacy,” he said, noting that elevated frequency and severity trends in cat losses, and exponentially growing losses from secondary perils like convective storms, floods and wildfires outpaced those rate increases.
Entering 2023 “with this baggage of six years of underperformance,” Khasnis said reinsurers have taken more significant actions, describing both hard market conditions in the short-tail lines and firming in casualty pricing. Together, improving underwriting conditions, along with rising investment income “could bode well for the reinsurers profitability in 2023,” he said, introducing the idea of a tipping point for the S&P rating outlook.
“If the sector demonstrates its ability to earn its cost of capital on a sustainable basis that could be the turning point where we could revise our view of the sector back to stable,” Khasnis said.
Iten gave his own summary of “house views”—S&P’s outlooks—for the global reinsurance sector and the U.S. P/C insurance earlier in the day. Iten pointed to declining capital levels as a key reason for S&P’s dim views of both sectors. For the U.S. P/C sector, higher catastrophe losses and floundering personal lines underwriting results also started to change the distribution of rating outlooks for individual primary insurers, he said.
At the beginning of 2022, 90% of the U.S. P/C outlooks had been stable. But as the year progressed, 17% of the outlooks were moved to negative or credit watch negative, he said, flagging large personal lines insurance writers American Family, Allstate and Farmers among the primary P/C carriers on negative outlook currently.
S&P moved the U.S. P/C sector outlook to negative from stable last October for the first time in 10 years.
Like Khasnis, Iten said the picture looks less bleak on the reinsurance side, with the distribution of outlooks for individual reinsurers starting to shift in a positive direction. “Only 10% are negative,” he said. “That’s really two companies: Swiss Re and SiriusPoint,” Iten said, noting that 24% of the outlooks for global reinsurance had been negative at the beginning of the 2022. Several rating actions reduced that percentage, he said, including a downgrade for SCOR and upgrades for Fairfax and TransRe, along with several individual outlook shifts back to stable.
“2022 [reinsurer] earnings were again depressed by higher, above average property-cat losses. And so once again companies did not earn their cost of capital,” Iten said, supporting the continuation of the negative outlook last year. “And like P/C sector, [reinsurers] also suffered from declines in capital that are related to unrealized losses on their bond portfolios. But the positive coming in so far this year is that [reinsurers] have been able to put through some very significant rate increases and also make some changes in terms and conditions that should help their profitability this year.”
“If reinsurers can increase their profitability, and we think it’s sustainable, then that could be signal a change back to a stable outlook.”
At several points during the S&P conference, Iten explained S&P’s treatment of capital in its assessment of insurer and reinsurer ratings, noting that the rating agency looks prospectively at projected capital adequacy levels two or three years into the future.
The downward impact of rising interest rates on capital was a major reason for the U.S. P/C sector outlook change and for the continued negative outlook on the reinsurance sector, he said, adding that “capital historically has been a relative strength” for both sectors.
For the U.S. P/C insurance sector, in aggregate, the GAAP filers rated by S&P were 16% redundant at the double-A level going into last year—and most of them are rated at a single-A level, Iten reported. “Our estimate is that that came down to about a 3% redundancy at the end of the year. So, most of that cushion did go away. What that means is that most of the companies that were not at or above that average level—some of them, with less strong capital coming in—are now materially below where we think capital should be for their rating level.”
For reinsurers, Iten reported that the sector’s capital fell by $100 billion, or 15%, last year. “Like the P/C sector, most of these companies entered the year with capital as a relative strength,” he said, then turning to an explanation of S&P’s treatment of capital in individual ratings assessments.
“It’s important to remember that for both of these sectors, we’re not rating to where capital is at the moment. We are looking out to the end of our projection period, which is typically two to three years. So, even if a company is below expectations now, in our forecast they’ll get credit for the earnings we’re projecting, they’ll get credit for the pull-to-par effect on their bond portfolio, and they’ll also get credit for an initiatives that are within management’s control—things like reducing share repurchases or dividends, issuing more debt or hybrid capital, or cutting back on the amount of business they write or changing their reinsurance structure.”
“There are a lot of things that can be done, and it’s really only at the end of the day if none of that really is enough to get them back to where they need to be, [when] you might see a rating action.”
Later, during the session he moderated, an equity analyst and a fixed income analyst both said that they look beyond temporary capital declines from unrealized losses related to rising interest rates—because carriers and reinsurers are unlikely to be forced to liquidate holdings to pay claims. An audience member then pressed Iten to explain why S&P can’t look past them too.
“Is there any point where there’s an inflection point—where you guys will say, ‘OK, now this is not really as big a negative on the outlook for the industry? Where is that point?” the audience member asked.
“It is what it is,” Iten said. “The unrealized losses are there. That has reduced shareholders equity significantly for a number of companies,” he said, reiterating that S&P’s look at capital is prospective.
“Nobody’s seems to really be expecting [interest] rates to go up much more. So, we don’t really see a lot of downside, at least, over the near term…..The most important thing is how much of a difference those other factors over the projection period can make. And we’re talking about, hopefully, some pretty significant earnings, particularly if it’s a commercial lines company. They’re making a lot of money. And hopefully the personal lines companies will start making money too,” he said.
Two Hard Markets, Two Different Outcomes
Elyse Greenspan, managing director of Wells Fargo, and Chad Stogel, vice president-research for Spectrum Asset Management, gave their own assessments of the personal lines insurers and reinsurers, and the impacts of hard markets in those industry subsectors. Stogel predicted profitability for reinsurers that won’t soften prices in 2024. For personal lines insurers, however, profits could remain elusive, Greenspan said.
In personal lines, “we are in a hard market but we have not reached inflection with price coming in above loss trend,” she said, noting that elevated loss severity and the regulatory lag in getting rate increases approved have stalled the margin improvements of a typical hard market.
Stogel added, “Traditionally we didn’t really have to worry that much about personal lines getting in trouble because you reprice. But as a follower utility sector, in some states, it’s become like utility regulators not allowing you to recover your costs—and that’s the problem.”
Iten asked the analysts to guess when the personal lines sector might get to pre-pandemic profitability, and Greenspan expressed reservations about it happening in 2024.
Given that many personal auto policies have six-month terms, analysts might have predicted that it would take at most nine months—at most, a year—for carriers to return to target underwriting margins, even factoring in the lag for price hikes to earn into insurer portfolios. “We started talking about elevated severity from the personal auto sector in the summer of 2021. Twenty-four months later and we’re still talking about elevated severity in the personal auto sector,” she said.
Insurance companies that offered guidance to analysts this year have said that while this year is still shaping up to be bad, they believe they’ll get back to target margins in 2024, Greenspan reported. “Do I do I think that’s possible?” she asked rhetorically. Even as regulators start letting more rate into the system, “the big unknown is just what happens to severity.” If severity remains elevated, it will be “really hard” for companies to mid-90s combined ratio targets.
“My view is they’re not taking price assuming that severity is perpetually going to be in double-digits.”
Stogel said another “wildcard element” for personal lines insurers is the restructuring of the reinsurance treaties. “They don’t have the aggregate covers that they may have had” in the past, he said, noting that loss frequency from cat events will hit personal lines players in a different way than it did previously.
“On the demand side, maybe we’ll see the personal lines players start to rethink their earnings volatility, and step back in to cover themselves” with more reinsurance. “They’re going to have to pay for it obviously.”
With everyone agreeing that reinsurance is moving in the right direction, Iten asked Stogel whether he expects to a see an inflow of new capital to shore up the overall capital position of the sector.
“In a relatively benign or a normal year [for catastrophe losses], if we’re seeing 20-plus percent ROEs, that capital hole gets filled,” Stogel said, noting that increased prices and risk-remote, high attachment points are making such returns on equity possible for reinsurers. “They’re going to return capital to shareholders. There’s going to be other uses. But that capital hole gets filled,” he said.
As for skittish insurance-linked securities investors who have gotten burned year after year by issues like trapped capital, he said, “If they see that these returns are real, I can imagine that some of it’s going to come back. You don’t need that much at that point to fill the hole.
Greenspan said a lot does depend on what happens during wind season, agreeing that programs have really been restructured to offer the reinsurers the potential to generate a strong return in an average season. Still, “I’m not sure that the ILS capital will necessarily come back in vs. saying, ‘It’s one year. We got lucky,” she said, suggesting that multiple years of profit would be needed to entice ILS capital back into the reinsurance sector.
Stogel asked and answered the question of whether capital replenishment from earnings is going to make soften reinsurance prices. “Not necessarily. But I think they’ll stabilize here.”
He added: “It’s like inflation, right? Everybody says we want to get back to 2% inflation. It doesn’t mean you’re better off than you were five years ago. It just means we’re stabilizing. If we were up at 5% inflation, 7%, you’re still way worse off than you were five years ago. [Likewise], if pricing flattens, we’re still in a much better place than we were a few years ago.”
At a different session during the June S&P conference, reinsurance executives also advanced the view that reinsurance rates would remain stable and adequate at 1/1/2024. Kevin O’Donnell, president and chief executive officer of RenaissanceRe Holdings Ltd., actually pointed to pressure coming from investors supplying reinsurance capital and their mandates for higher returns on their investments as a reason for sustained rate adequacy.
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