In June, Moody’s Investors Service changed its outlook on the global reinsurance sector to negative from stable, noting that the current soft market has traits similar to the one that persisted in the late 1990s.
There’s one key difference, however, says Kevin Lee, vice president and senior credit officer. Reinsurance “buyers today have greater incentives to improve capital efficiency, limiting their need for reinsurance.”
“Tighter regulatory oversight and the need for better internal governance have pushed insurers to get more mileage out of their capital.”
The resulting lower demand for reinsurance just adds another layer of problems to conditions reminiscent of the 1990s soft market— an overabundance of capital, double-digit annual price declines, a substantial rise in buyers’ bargaining power, and predictions of industry consolidation, he notes in a report titled, “Global Reinsurance Outlook Turns Negative.”
As was the case in the late 1990s, reinsurers are selling multiple year contracts to hang onto business, and questions about what, if anything, could turn the market abound, Lee notes in the report.
Giving some specific examples of the actions of reinsurance buyers, Moody’s notes:
- Allianz SE has reduced annual reinsurance spend by €1.1 billion ($1.5 billion) since 2006 by consolidating reinsurance purchases across the group. The company bundled local risks onto a central balance sheet. Then buying reinsurance as a cohesive unit, Allianz was able to retain more risk—taking advantage of diversification benefits—and bundle higher volumes to increase negotiating clout with reinsurers.
- Zurich started centralizing P/C and life reinsurance purchases in the early 2000s, reducing the percentage of premiums ceded from 24 percent to 16 percent between 2002 and 2013.
- AIG reduced annual P/C reinsurance spend by $1.1 billion since 2009.
Moody’s negative outlook represents the rating agency’s view of the sector over the next 12 to 18 months.
Things could get even worse.
In a segment where “nontraditional” capital from investors has pushed catastrophe reinsurance prices down to pre-Hurricane Katrina levels “without a clear floor,” another 15-20 percent drop next year would push prices below 2001 levels—before the Sept. 11 attacks, making it hard for some reinsurers to earn their cost of capital.
That would make Moody’s outlook even more pessimistic, the report says.
While some believe a large catastrophe event, particularly in Florida, could scare away some of the nontraditional capital and fuel a market turn, Moody’s notes that the prospect of higher prices could attract new inflows, “taking the steam out of any hard market.”
Citing another difference from the 1990s, the report discusses the impact of low interest rates, which sharply contrast the high rates and booming stock market that fueled loose underwriting and “a sea of red ink” during the previous soft market.
But lower rates now aren’t forcing reinsurers to tighten terms and raise prices. Instead, with the lower interest rates and a quest for diversification is attracting the nontraditional capital from pension funds, endowments, institutional investors and high-net worth individuals to the property-catastrophe reinsurance arena—and the new low-cost providers are compounding an oversupply of capacity in a product line that “hold high strategic stakes for many reinsurers.”
“Higher interest rates could lead to some outflow of nontraditional capital, but we think many investors are equally motivated by diversification,” the Moody’s report says.
Delineating some of the direct and indirect effects of the market disruptions created by nontraditional capital in the catastrophe reinsurance market, Moody’s notes that catastrophe reinsurance:
- Drives industry results in big-loss years and no-loss years.
- Subsidizes less profitable product lines, including certain casualty reinsurance lines “that are barely producing breakeven underwriting results.”
- Dictates reinsurers’ capital needs and capital structures.
Explaining the last point, the reports notes that even if catastrophe reinsurance contributes only 10-20 percent premiums for a reinsurer, it can consume up to 50 percent of underwriting capital. A reinsurer that shrinks its catastrophe reinsurance book will either have to redeploy or return significant sums of capital. This may mean realigning strategy and personnel, or elevated client concerns about doing business with a smaller company, among other issues.
No reinsurers are immune from the challenges that exist today, the report says. But some are better positioned to deal with them than others, including those with both insurance and reinsurance operations.
“We believe reinsurers that are best positioned to cope with the sector’s challenges are those that have already demonstrated their strategic relevance to clients and possess relevant size, superior claims service, whole-account capabilities, and a solid insurance platform,” notes Lee.