March 13, 2015 by Terri Goveia
Earlier this year, the International Credit Insurance and Surety Association asked its members a critical question: Would the reinsurance market harden, stay the same or continue to soften? Mike George, president and CEO of Trisura Insurance, recalls the overwhelming consensus on the matter. “One hundred percent [of respondents] said it was going to soften further.”
That’s an easy prediction, given the current state of the market. Loaded with new capital and excess capacity, more than one global reinsurer has echoed the ICIS membership’s projections in its quarterly statements. But, even as the immediate effects of the reinsurance soft market emerge in lower prices and creative solutions, the fallout on the broader industry— including brokers—is still playing out.
“The rate of change is unprecedented,” says George. “In a lot of ways, the uncertainty of what the landscape will look like is more challenging than it’s ever been.”
Several factors are bearing down on reinsurers. A relatively quiet cat year has helped boost capital, but so has a steady stream of new capital in the form of catastrophe bonds, sidecar investments and so-called “hedge fund reinsurers.”
At present, third-party capital accounts for roughly $59 billion U.S. of the total $570 billion in global reinsurance—and is set to reach $130 billion U.S. by 2018, according to Aon Benfield’s most recent Reinsurance Market Outlook.
That leap is a real possibility, according to Greg Reisner, managing senior financial analyst at A.M. Best. “That trend has been growing for the past several years, and it’s expected to continue.” While he estimates that alternative capital currently accounts for roughly 15 or 16 percent of the market’s current global property limit, “will it wind up being 25 percent or 35 percent of the capacity? We’ll see in time. I think a good chunk of it is here to stay.”
Proportions aside, the current reinsurance landscape is a boon for primary insurers, who are finding reduced pricing across all property-cat lines. “This is a good news scenario for our clients,” says Bryon Ehrhart, CEO of Aon Benfield Americas in Chicago.
And benefits aren’t limited to price. Alternative capital is also driving better value propositions for insurers looking to bolster their own capacity, Ehrhart says, noting that they can approach today’s reinsurance market with a sizable wish list. “Many clients in tighter markets have bought what they needed, rather than what they’d like to have,” he points out. “With alternative capital, it’s possible that they can buy something that’s closer to what they want, and they’re willing to spend some of the savings to get it.”
Has the reinsurance ripple effect reached street level here? In Canada, it’s just one factor in an already competitive market, says Keith Walter, senior advisor at Deloitte Canada. He adds that the third-party capital phenomenon has had a decidedly global bent. “It hasn’t yet had as big an impact in Canada as it has in other markets.” He notes that the closest deals involve North America, with Canada as part of that package. “[But] it’s out there as a potential [scenario], and everyone is very sensitive to that,” he says, suggesting that the market may be reacting “before it’s hit us.”
Competition is a bigger factor here. Although Walter sees some price increases in response to last year’s flooding in Ontario and Alberta, “competitive pressure [on the commercial side] is strong, unless there’s a specific catalyst to increase prices, the trend is downward.”
George agrees that the ripple effect is coming from different directions. The size of Canada’s insurance market actually offers some protection from price swings, he points out. “Think about a $50-billion business that has $1.8 billion in reinsurance. If the cost goes up or down by 10 percent, that’s not a huge deal in the grand scheme of things. It’s a pretty small piece of the overall insurance pie.”
It may not put pressure on Trisura’s own rates, but it gives George some leeway. “If I can buy my reinsurance cheaper, or cede a little less, then I can reduce my overall pricing to a degree. It affords me that luxury.”
That’s certainly good news for insurance buyers, but the implications for brokers are more challenging. Current pricing adds another stressor on brokers already battling for business alongside low interest rates and intensifying consolidation. “There’s no doubt that the lack of hardening at [the reinsurance] level is prolonging the soft market we’re in,” says Daryn McLean, owner of the Moore-McLean Insurance Group in Mississauga, Ont. “It’s having a huge impact on commercial insurance brokers’ top lines.”
Clients—eager to trim one of their larger expenses—intensify soft market challenges. Brokers getting a 15 percent or 20 percent commission now get that same commission on lower premiums, notes George. “I feel for the brokers, because they’re caught.” “Our industry allows them to save money by switching,” says McLean, pointing out that standard retentions are around 92 percent. “We have to write at least 7 percent to 10 percent to get a lift, so you have to write double-digits just to get where you were the year before.”
His own brokers emphasize the expertise they can bring to specialty clients that can provide value and help build assets, he says. “The insurance program is just one of those factors.”
On one hand, that approach will have the most payoff, according to Ehrhart. “Anybody with a business that’s tied to a percentage of premium [with] premium going down, is going do what brokers do: try to find a way to use the capacity to help the client meet more of their objectives.” Although, that’s actually another factor driving prices down, Walter points out. “[Brokers] are getting better at helping clients negotiate the best possible price.”
Many brokers are seeking out scale in response to flat organic growth. “They’re hungry to grow. It’s becoming difficult for a broker to fulfill all their insurer relationships,” says McLean. “There are a lot of conversations taking place in the market right now about what [certain] brokers coming together might look like, and what that means for the staff, clients and insurance partners.”
Recent deals involving Arthur Gallagher and Noraxis and the more recent creation of Navacon—the result of a partnership between Jones Deslauriers Insurance Management, Lloyd Sadd and Fairfax Financial Holdings—bear out the trend as brokers bid for market share, notes George.
Such deals are reshaping the business. “When I first got into the business, it was easy to know who was who,” says George. He points to the chain reaction stemming from plentiful capacity and capital—with reinsurers hedging bets by creating primary insurers, primary insurers buying brokers and brokers buying MGAs. “Today’s it’s hard to know who’s who.” The buying spree is actually creating a new breed of broker, according to Walter. As acquisitions consolidate businesses, they also compound specialized expertise and technical skill. “Their ability to bring value to the clients continues to improve.”
Still, against the pricing and competitive backdrop, scale may not be enough. Some brokers are also turning to insurers for relief, says George. “There’s an upward pressure on insurance companies to pay more in terms of base commission and contingent profit sharing.”
And some are taking more drastic steps. “If you’re trying to provide your client with excellent guidance and insight, and you’re making less money every time as a broker, at some point, that’s got to give. Some brokers are saying, ‘This customer just isn’t profitable for me anymore.’”
Daryn McLean agrees that current conditions could prompt “more sophisticated brokers” to walk away from business. “Those situations are hard to see but I know they’re happening.”
At certain levels of fee-based business, where the premiums reach into seven figures, he’s also seen the opposite approach, with brokers replacing business for free, just for the residual commission. That’s not something all brokers are willing to do. “We’re not going to take a loss just to get an account.”
Among some insurance players, there’s a sense that things have shifted permanently, although questions linger over new capital activity even as it accelerates. Some thirdparty players “muddy the waters,” notes George. “You have some naïve players… are they being opportunistic? Are they [only] here for the short term?”
Those are questions insurers should heed, cautions Reisner. “I don’t think primary insurers want to get into a position where they’re dependent on cheap reinsurance. It will change at some point in time. They want to be careful how they approach that.”
But it’s more likely that the new capital will linger for some time. “We spend a lot of time talking about how we can take alternative capital into other lines of reinsurance,” says Ehrhart. But he points out that there are other, natural avenues for the funds—and the first option is likely into the primary property insurance market.
“Strong insurers will find a way to manage the value that’s available in alternative capital into their value propositions …just the way reinsurers have had to scramble to stay relevant,” he predicts, pointing to the opportunity to take large property schedules and consider the critical business risks for those corporations. “Many of those corporations could use additional limits.”
If there’s no upper limit to third-party capital, street-level players are still trying to find their own lower limits. “I joke that three years ago a policy cost $1,500, two years ago it was $1,200, this year it’s $900, next year it will be $700, and the next it will be $299 and a free pizza,” says George. It’s a joke, but the punch line is serious. “If that’s the way business is going to be done, [we’ve] got to get ready for that.”
Moody’s: “Moody’s…changed its outlook on the global reinsurance sector to negative from stable. The outlook change was prompted by a number of factors that are pressuring reinsurers simultaneously: an oversupply of capacity, new entrants in the form of non-traditional capital, more substitute products, low interest rates, and greater bargaining power of buyers. The current soft market shows many of the traits of the late 1990s—an overabundance of capital, double-digit annual price declines, a substantial rise in buyers’ bargaining power, and predictions of industry consolidation. But the forces fueling the current market situation are not exactly the same.”
Fitch: “Fitch Ratings’ fundamental outlook for the reinsurance sector is negative, as intense market competition and sluggish cedent demand has resulted in a softening market for reinsurers. In addition, the onslaught of alternative capital, which Fitch views as enduring, leads us to expect that prices will continue to fall, and for terms and conditions to weaken into 2015 across a wider range of business lines.”
S&P: “Competition from traditional and nontraditional sources in reinsurers’ core markets is forcing them to make adjustments to retain their relevance in a rapidly changing global economy. Standard & Poor’s Ratings Services believes that the traditional reinsurance business model is under threat from external sources, such as corporations and technology companies that could become substitute providers of risk protection. If reinsurers fail to make use of their key strengths and expertise to establish their relevance to new and existing clients, the traditional reinsurers could find themselves marginalized. […] In January, we revised to negative our view of credit trends in the reinsurance market. We continue to see downward pressure on the sector as competition increases, and we expect this to weigh on reinsurers’ ability to generate acceptable returns over the next 12 to 24 months.”
A.M. Best: “Traditional balance sheets are evolving with the market and the reinsurance sector for a long time has been innovative and nimble. However, it is difficult to stray away from the simple fact that compressed investment yield and compressed underwriting margins strain profitability. That ultimately places a drag on financial strength. That being said, A.M. Best has revised its reinsurance sector outlook to negative. However, at this point [September], A.M. Best’s view is longer-term than the typical 12-18 months. Broadly speaking, rated balance sheets are well-capitalized and capable of withstanding various stress scenarios. […] If the market fundamentals continue on this current trend, then the likelihood of negative outlooks and downgrades will continue to heighten as the side effects of compressed underwriting and investment yields are well-known.”
Copyright 2014 Rogers Publishing Ltd. This article first appeared in the November 2014 edition of Canadian Insurance Top Broker magazine
This story was originally published by Canadian Insurance Top Broker.