A.M. Best report shows investors still turning toward Cat bonds to improve investment performance, explores underwriting cycle for reinsurance industry

Capital continues to be drawn to the reinsurance industry despite the fact that fundamentals are trending in the wrong direction, suggests a special report issued Monday by A.M. Best.

The annual segment review of the global reinsurance industry – How Relevant Is The Underwriting Cycle? – explores whether or not the traditional underwriting cycle has grown distorted. “Investors continue to turn toward catastrophe bonds to improve investment performance, despite risking the entire principal over a relatively short-term period,” notes a statement from the ratings agency.

A.M. Best recently revised its ratings outlook on the global reinsurance industry to negative from stable, but at this point, the view is longer term than the typical 12 to 18 months. “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,” notes the special report. “In this type of operating environment, companies with the advantage of diverse business portfolios and distribution are likely better positioned to withstand the pressures and target profitable opportunities as they arise,” the report adds.

“The flurry of convergence capital has triggered behavourial changes by the market’s traditional players, with more company names appearing for the first time on reinsurance programs in atypical geographies,” A.M. Best notes in the statement. “The trend started as a trickle, but the impact of third-party capital on property catastrophe rates has displaced capacity to other lines of business and geographies,” adds the report.

“While there will be winners and sinners among the players and more capital in the (re)insurance market, the ultimate winner over the near term will be the reinsurance buyer,” notes the report. “Through that lens, this is all positive. But it is the long-term proposition that really matters for all the parties involved and that outcome is still very unclear,” A.M. Best cautions.

The ratings agency further cites a pattern in the catastrophe bond market: the increasing value of certain bond issues and declining coupon payments.

While in 2013, 30% of the issues increased in size before the deal was completed, so far in 2014, 39% of the issues have increased in size, implying a continued increase in demand for certain market offerings. At the same time, the statement notes, 51.2% of catastrophe bonds issued in 2013 had a coupon payment of 500 basis points or better, a number that has dropped to about 42.2% so far in 2014.

“While third-party capital increasingly enters the reinsurance sector through catastrophe bonds, sidecars and hedge fund reinsurance companies, the quick exit strategy has always been a focus,” the report states. “As of late, it appears that more hedge fund reinsurers that are seeking a rating are looking to partner with an existing (re)insurance company as opposed to going it alone. An obvious benefit is that it taps an existing underwriting team that has an active book of business with a known track record and well-established relationships,” it adds.

“From A.M. Best’s perspective, alignment of interest means not only sharing in the upside performance, but all parties also equally share the pain if results disappoint. This is extremely important from a qualitative perspective when A.M. Best assigns a rating to such a newly created entity,” the report emphasizes.

With regard to underwriting results, given the lack of any major events in 2013, the report notes most reinsurers delivered underwriting profits and solid earnings. “Combined ratios for most were below 100, driven in part by continued reserve releases and well-diversified books of business,” the special report states.

“The growth in capital once again outpaced the growth in net premiums written (NPW), which together with alternative capacity in the form of catastrophe bonds, sidecars and other structured products, continued to fuel aggressive rate competition,” A.M. Best reports.

The company points out that that so far in 2014, more than US$6 billion of capital has flowed into new cat bond issues alone, compared with US$7.6 billion for all of 2013.

The report – which includes a ranking of the top 50 global reinsurance groups in 2013 and geographic breakouts of reinsurance segments – says most traditional reinsurers maintained their market share. The majority of movement occurred among the ranking’s bottom two-thirds.

The top three companies in the ranking are Munich Reinsurance Co., Swiss Re Ltd. and Hannover Rueckversicherung AG, while the only change in the top 10 was SCOR S.E. advancing ahead of Berkshire Hathaway Inc.

“Gross premiums written (GPW) among the top 50 grew 2.8% compared with 2012, while non-life GPW alone increased by 1.7%. The increase could be a result of some selective opportunities in specialty lines, as well as growth into emerging markets by some global players,” the report adds.

“Benign catastrophe years can mask a weak earnings environment, but as market traction diminishes for traditional companies, the side effect of reduced earnings power burgeons,” states the report. “It has always been best to view reinsurance earnings not just quarter-over-quarter or year-over-year, but rather over several years,” it adds.

“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,” states the report.

It notes that the reinsurance sector’s 2013 year-end results and 2014 year-to-date results “positively skew earnings trends and prospective earnings potential, and ignore that companies are being paid less and less to bear risk.”

While traditional reinsurers have taken steps to partially offset this risk, “given where rate adequacy is, it will continue to take optimal conditions, including benign or near-benign catastrophe years, a continued flow of net favourable loss reserve development and stable financial markets to produce even low double-digit returns,” the report cautions.

Other findings from the special report include the following:

• most Asian reinsurers’ results were favourable in 2013, but a dramatic softening of the market, in line with the global market, along with consolidation, may increase potential volatility;

• MENA (Middle East & North Africa) domiciled reinsurers have a strong presence in a single market, benefiting from compulsory cessions or have limited their exposure, and have demonstrated a track record of profitability; and

• Africa’s highly competitive insurance markets continue to attract scrutiny and rising interest from around the world, particularly from parties in the United States and Europe.

“Looking forward, the overall market environment remains challenging, and comp
anies for the most part are realistic about the returns they can achieve in the current market. Pricing is not expected to improve for the Jan. 1 renewal, absent any major event,” A.M. Best adds.