Alternative capital can play hard in 2018 again

Traditional reinsurers have been complaining for a while that rates are unsustainably low. Overcapacity in the market is often blamed, driven by the growth of alternative capital. But alternative capital has emerged strong after the 2017 hurricane season, and traditional reinsurers are also in good shape for the upcoming renewal negotiations. A combination, that does not bode well for the desired improvements in rates.

Investors like reinsurance

Looking for better yield in a low interest rate environment and investments with risks uncorrelated to other assets in the portfolio, investors have been steadily increasing their participation in the alternative reinsurance sector.

Pension funds, sovereign wealth funds, endowment funds and high net worth individuals are seeking direct exposure to insurance risk as part of a diversified investment strategy. They generally have a long-term investment horizon and operate with a relatively low cost of capital.

Funds are usually deployed via specialist insurance-linked securities (ILS) fund managers and products include collateralized reinsurance contracts, catastrophe bonds, reinsurance sidecars and industry loss warranties (ILWs).

This capital has a disproportionate impact on the US property catastrophe and global retrocession markets, as collateral provision and rollover favours lines of business with early loss recognition and risk assessment is dependent on reliable modelled data, Aon Benfield states in its April 2018 Reinsurance Market Outlook, noting that it is, however, beginning to be applied in other areas.

2017 losses were manageable

Alternative capital showed significant growth over the course of 2017, increasing to $89 billion from $81 billion in 2016 and $72 billion in 2015, according to Aon Benfield. Losses in the second half of 2017 particularly through hurricanes Harvey, Irma and Maria (HIM) and wildfires in California, tested the market. Institutional investors responded by showing renewed commitment to an asset class that has delivered relatively attractive, non-correlating returns over time, the broker noted in the report. In 2018, catastrophe bond activity has been at record levels for a first quarter and Aon Benfield expects to see further growth in alternative capital during the year.

Overall, global reinsurance capital grew 2 percent year on year in 2017 to $605 billion, despite record insured natural catastrophe losses of $136 billion, according to Aon Benfield. But for the reinsurance sector, the impact was manageable due to a number of factors, according to the broker. For one, a portion of the losses from the major events in the US were retained by various government agencies. The amount is estimated at around $20 billion, according to the report. Also, the reinsurance market picked up a relatively low proportion of the private sector losses, less than one third according to estimates, due to the generally high retentions carried by primary insurers. In addition, within traditional reinsurer earnings, elevated catastrophe losses were mitigated by continued favourable prior year reserve development and better than expected investment returns.

Traditional reinsurers have also managed to absorb the 2017 catastrophe losses. Total equity across the Aon Benfield Aggregate (ABA) constituents, a group of 21 major reinsurers including Hannover Re, Swiss Re and Munich Re, rose by 2.5 percent to $204 billion over the year to December 31, 2017. This outcome was, however, flattered by a 14 percent year-on-year weakening of the US dollar versus the euro – the reporting currency of four of the largest companies in the study, the broker noted.

Gross premiums written by the ABA group totalled $249 billion in 2017; the volume of P&C business stood at $174 billion, with primary insurance up 8 percent to $89 billion and assumed reinsurance up 5 percent to $85 billion, according to Aon Benfield. P&C net premiums earned rose by 6 percent to $144 billion.

The large European reinsurers continued to report growth in structured reinsurance solutions, with demand emanating from North America and Europe, Fitch noted in an April 16 Special Report. Hannover Re, for example experienced growth of 53 percent in this business at January renewals, the agency said.

But natural catastrophes in 2017 did impact reinsurers’ combined ratio, which went up to 107.4 percent, taking the five-year average to 94.7 percent, according to Aon Benfield. Net natural catastrophe losses of $23.6 billion contributed 16.4 percentage points (pp), with around a quarter of these losses derived from primary insurance operations. At least $1 billion of the reported reinsured losses were ultimately passed to the alternative market, via third party investors, the report says.

Reserve releases of $5.9 billion benefitted the combined ratio by 4.1pp in 2017, the reduction relative to prior years being partly influenced by the unexpectedly severe cut in the Ogden discount rate in the UK (an outcome which is likely to be partly reversed in the coming months), according to the broker.

The four major European reinsurers have all reported significant combined ratio deterioration on their P&C reinsurance business, of between 6pp and 19pp, with all except Hannover Re reporting an underwriting loss, Fitch said. Hannover Re’s P&C underwriting result benefitted from significant reserve releases, which helped to offset the high level of natural catastrophe losses. Despite the poor performance of the P&C reinsurance business, all four European reinsurers managed to generate positive net income for the year as a result of strong and stable results in life reinsurance and solid investment returns, according to the agency.

At the same time, the investment returns of the ABA constituents generally exceeded expectations in 2017, despite the impact of persistently low interest rates, Aon Benfield noted. The ordinary yield appears to have bottomed-out at around 2.6 percent and significant capital gains resulted in an improved overall return of 3.7 percent.

Investment returns were solid in 2017, with SCOR and Hannover Re also benefitting from one-off investment gains, Fitch added. Hannover Re liquidated its equity portfolio, realising significant gains whilst SCOR benefitted from a €192 million capital gain on a real estate sale realised in the fourth quarter of 2017, the agency noted.

However, the improved investment returns could not prevent a sharp drop in profitability. Across the ABA as a whole, pre-tax profit fell by 75 percent to $5.1 billion in 2017. Net investment income of $20.6 billion and capital gains of $8.9 billion were partly offset by P&C underwriting losses of $10.6 billion and other charges of $13.7 billion, according to Aon Benfield.

Nevertheless, the four major European reinsurers posted overall profits for 2017, despite significant catastrophe losses, Fitch Ratings noted in an April 16 special report. With the exception of Hannover Re, they recorded losses on their property and casualty (P&C) re/insurance underwriting, but positive contributions from life and health re/insurance, and solid investment returns more than offset these. Nevertheless, overall profits for 2017 were significantly lower than in 2016, the agency noted.

Life reinsurance has helped balance the nat cat impact in 2017, continuing to contribute strong profitability to the reinsurance companies, despite deterioration in the performance of US mortality business, driven by franchise growth in traditional markets and emerging economies, Fitch noted.

Rate improvements disappoint

The January 2018 renewals period marked a return to rate improvement following four years of reductions, Fitch noted, but disappointed expectations after the 2017 record losses. The rises were moderate, with pricing remaining below 2015 levels for most reinsurers and significantly below the recent high point for rates, in 2013, the agency said.

SCOR experienced the biggest overall rate increase of 3 percent, which reflected a 7.8 percent improvement on the non-proportional business and a 1.7 percent improvement in proportional treaties, Fitch said. Whilst SCOR reported the most rate improvement, French player reported the lowest overall top-line premium growth. By contrast, Munich Re reported the largest overall top-line growth at 18 percent (driven by several large transactions) but the lowest rate improvement of 1.6 percent (when adjusted for interest-rate changes), according to the Fitch report.

Overall, at January renewals there was improvement across most lines with particularly large enhancements on non-proportional UK motor reinsurance (due to changes to the Ogden discount rate) and non-proportional property catastrophe business, particularly in the US, Fitch noted. The renewals on proportional business showed much lower improvement across the board, particularly when not driven by catastrophe losses. These trends continued at April renewals and Fitch expects rate improvements to remain muted in the absence of further significant catastrophe losses.

While all four major European reinsurers reported an improvement in rates these increases did not offset the previous four years of falling rates, Fitch noted.

Major losses have been below average so far in 2018 and capital market conditions have been relatively benign, the Aon Benfield noted, concluding that global reinsurer capital remains at peak levels ahead of the mid-year renewals in June and July, which will likely result in strong competition, even for loss-impacted business.