Cat pricing pressure likely to haunt re/insurers for a while

Expectations that a jump in cat losses in the second quarter may boost prices in the upcoming renewal season and boost re/insurers’ profitability are likely to be disappointed because capacity remains high. Carriers such as Swiss Re are preparing to cut underwriting business as lower investment returns are already weighing on profitability.

A number of natural catastrophes have driven up re/insurers’ losses in the second quarter, impacting the financial results of the sector which are already battered by low interest rates. A wildfire in the Canadian city of Fort McMurray, for example, caused catastrophic damage throughout the month of May, becoming the costliest natural disaster in the country’s history, according to Aon Benfield’s catastrophe model development team. Losses are expected to exceed $3.1 billion.

A number of other events including earthquakes in Ecuador and Japan and floods in Europe added to claim volumes in the second quarter, weighing on results of a range of carriers such as Chubb, XL Group and Swiss Re.

XL Group, for example, faced natural catastrophe pre-tax losses net of reinsurance and reinstatement premiums in the second quarter of $240.1 million or 9.8 points to the loss ratio, compared to $59.9 million or 2.9 points to the loss ratio, in the prior year quarter.

Chubb reported total pre-tax catastrophe losses for the quarter of $390 million or 5.7 percentage points of the combined ratio compared with $124 million or 3.2 percentage points of the combined ratio in the same period of 2015.

These losses have fuelled hope that prices for catastrophe re/insurance will rebound. In the absence of larger losses in the past, catastrophe rates have been falling for a while. Since 2010 catastrophe reinsurance prices declined by around 20 percent with an acceleration of the trend in the last three years, according to Hiscox’s  first-half results presentation.

Lured by the absence of big losses in the past 10 years, alternative capital poured into the segment, increasing capacity and helping to drive down prices particularly in catastrophe reinsurance, Aon Benfield analyst Mike Van Slooten says.

“The new capital that came into the industry targeted the highest-margin business, impacting the traditional sector’s results,” he explains.

“We have an unbalanced supply-demand relationship in the natural catastrophe reinsurance market,” Swiss Re’s group chief executive officer (CEO), Christian Mumenthaler, said during the company’s second quarter results presentation. And the sector will not be able to cope with much more pressure on rates, he noted. “We are hitting a point where we are no longer creating value for shareholders,” he warned.

Swiss Re’s combined ratio in property/casualty reinsurance worsened to 101.0 percent in the second quarter from 92.9 percent in the same period a year ago. Net income in the segment dropped to $283 million from $461 million over the period.

“The P&C [property/casualty] pricing cycle is clearly a huge challenge for us because P&C both in corporate solutions and P&C Re are key items,” Mumenthaler said. But the natural catastrophe losses in the second quarter will not, on their own, “move the needle,” he notes.

Van Slooten agrees: “You are talking about an earnings impact in one quarter rather than a series of events that has impacted capital positions and therefore causing changes of behaviour in the market. The supply/demand equation hasn’t really shifted,” he says.

SOME RATES IMPROVING

Carriers may, however, see rates improving in the regions affected by natural catastrophes in the second quarter.

“Reinsurance rates were up substantially” where the Fort McMurray wildfires took place, John Doucette, Everest Re’s CEO, noted during the company’s second quarter results presentation. “We seize the opportunity to deploy more capacity at higher pricing,” Doucette said.

But overall “there is still excess capacity in the market and as a result there continues to be downward pressure on pricing,” Van Slooten says. And this is unlikely to change any time soon because the low interest rate environment is set to remain in place for quite a while.

“Investment opportunities on the market are going to remain limited for a longer period, which means that catastrophe reinsurance will continue to be attractive for investors even though the return is a lot less today than it was two or three years ago,” he adds.

Investors such as pension funds can earn returns of about 3 to 5 percent with catastrophe reinsurance which is what a lot of them are looking for, Van Slooten explains. For a listed reinsurance company, however, “that wouldn’t be enough”.

But Mumenthaler suggested that reinsurers will reduce capacity as the business ceases to be economically viable, allowing prices to stabilise and even resulting in some recovery. The natural catastrophe losses in the second quarter are adding to a number of other drivers leading to pricing stabilisation, he said.

For one, less attractive margins will serve as a deterrence for the industry to deploy capital. In addition, the industry faces “less positive reserve developments” in the future. And the low interest rate environment, which is weighing on investment returns, adds to pressures which will, over time, lead to companies writing less business and start to scale back. If a company’s results don’t match investors’ expectations, the boardroom will start reacting and you will see some levelling out and then some rate increases, he predicted.

Swiss Re has already scaled back in the US natural catastrophe market and will scale back further if necessary, Mumenthaler said.

At Munich Re, gross premiums written in the reinsurance business field from April to June fell by 2.1 percent year on year to €6.96 billion.

“Past experience shows that one shouldn’t be among those who grow in a soft market and as a result is among the first to burn capital,” Torsten Jeworrek, head of reinsurance, said.

“We will introduce product innovations for which clients are prepared to pay for which can be related to reinsurance but not necessarily, and we might also shrink the business, that’s OK,” he notes.

Revenues at Berkshire Hathaway’s reinsurance units also shrank in the second quarter. General Re reported revenues of $1.4 billion for the second quarter, a decrease of 6.6 percent from $1.5 billion for the same period last year.

Berkshire Hathaway Reinsurance Group similarly reported a decrease in revenue for this period to $1.7 billion, down 15 percent from $2 billion, the figure for last year.

In the second quarter and first six months of 2016, property/casualty premiums written overall declined $23 million (5 percent) and $214 million (13 percent), respectively, while premiums earned decreased $82 million (12 percent) and $160 million (11 percent), respectively, as compared to 2015.

The company said the declines were born of pricing discipline and the willingness to walk away from under-priced business but also stressed it was very much open to large deals where the pricing was adequate.

“Our premium volume declined in both the direct and broker markets. Insurance industry capacity remains high and price competition in most property/casualty reinsurance markets persists. We continue to decline business when we believe prices are inadequate. However, we remain prepared to write substantially more business when more appropriate prices can be attained relative to the risks assumed,” the company said.

Reinsurers such as Swiss Re, which have been particularly affected by the higher capacity in the property/casualty segment, are not only feeling the pressure on the liability side, but also on the asset side.

“Lower interest rates do exert downward pressure on our results but we also do, very importantly, feel upper pressure on the need to maintain discipline on the underwriting side to make sure we continue to have profitable results from there as well,” Swiss Re group chief financial officer David Cole says.

If the situation deteriorates further, reinsurers might have to deal with disgruntled shareholders.

COVERING THE COSTS

“On the reinsurance side you got a large section of the market that’s now operating at single digit ROE,” Van Slooten says. “There are companies out there that in the current climate are struggling to cover their cost of capital. And that is something you can’t really do in the long term because your investors start to question the sustainability of your franchise,” he notes.

Swiss Re’s annualised return on investments dropped to 3.7 percent in the second quarter compared to 4.2 percent in the same period a year ago.

Similarly, return on equity dropped to 7.2 percent compared to 9.5 percent over the period.

“The outlook for investment returns is pretty grim,” Van Slooten says. “Even if interest rates started to go up tomorrow, you would still see reported investment returns declining probably for the next two years just on the basis of what companies are having to do today,” he explains.

The UK vote to leave the EU is expected to prolong the period of low interest rates. A large portion of re/insurance’s investments goes into bonds, many of which are offering negative yields.

Due to the low interest rate environment, “the underwriting side is contributing proportionately much more to reported earnings than it has in the past,” Van Slooten says. In order for prices to go up, an external event is required to impact the sector’s capital position and drive capacity out of the market, he says.

“It’s either going to be a loss on the asset or the liability side of the balance sheet, or possibly both. It’s fear that really drives change in the market.”
An event on the liability side that could potentially trigger a change in rates would be an exceptionally strong hurricane season in the US. However, even that may not be enough, according to Deutsche Bank Research.

“While in the past huge events led to price surges, we believe that these will be less pronounced than in the past,” Frank Kopfinger wrote in a Deutsche Bank Research analyst note.

He estimates that a 1-in-200-year hurricane would completely wipe out the capacity of public vehicles, 50 percent of the alternative market and 15 percent of the traditional market. But even then, the solvency ratios of four major reinsurers would likely remain strong and the low yield would quickly force fresh alternative capital to fill the gaps. For this reason, Kopfinger expects smaller price increases in the future than experienced in the past.

An event on the asset side that could change the price trend would be “a shock in the bond markets,” Van Slooten suggests. “That’s where potentially you could see some damage to the re/insurers’ balance sheets,” he says. “Because interest rates are at very low levels you’ve got unrealised gains on bond portfolios being reported that are actually supporting capital positions.”

Big, globally diversified companies are best placed to cope with the challenging environment for re/insurers’ performance.

“Just the size of the balance sheet means that the returns are going to be significant,” Van Slooten says.

“Reinsurance buyers are increasingly looking for partners that can support their growth ambitions as well as their balance sheet and it tends to be the bigger, more globally diversified companies with the underwriting know-how to operate in multiple classes of business that are able to offer that sort of coverage,” he notes.