Fitch: Have we seen the end of the traditional reinsurance cycle?

The past few years have seen natural catastrophe after natural catastrophe. There have been devastating hurricanes, record-breaking wildfires, typhoons, tsunamis, mudslides – you name it and the world has suffered through it. The global insurance and reinsurance markets have borne billions of dollars in catastrophe losses since 2017 – and the way things seem to be going with extreme weather, the catastrophe trend is showing no signs of slowing.

So, are the winds of change blowing the traditional reinsurance cycle off course? Traditionally, when the reinsurance sector took significant losses, it offset those losses with a big spike in pricing. In periods of more benign loss activity, the market responded with a corresponding reduction in rates. However, despite seeing significant catastrophe losses in 2017 and 2018, the global reinsurance market has not experienced a significant fluctuation in rates. This suggests a fundamental shift might have occurred within the market’s dynamics.

At the Fitch Ratings 2019 roadshow in London, UK, Fitch director Graham Coutts asked a room full of insurance professionals what they thought was the biggest issue facing traditional reinsurers in 2019. Almost half of respondents (48%) said the biggest issue was pricing approaching the cost of capital. Others said it was the growth of alternative capital (24%), significant catastrophe losses (23%), and M&A activity (5%).

“Capital in the reinsurance sector remains abundant – both from the traditional market and from alternative capital sources. That remains the case despite the significant catastrophe losses we’ve seen in 2017 and 2018,” said Coutts. “There’s a lot of supply and a lot of demand. Those factors seem to be cancelling each other out to some extent. That’s why [profitability remains under pressure] and the return on equity (ROE) for the sector remains quite constrained in the single digits. Not too many years ago, you would have said a lot of market participants would have wanted a minimum ROE of 10% in order to consider themselves profitable, but there seems to be a new reality where the ROE is more constrained than that. That’s one of the reasons why we might be seeing a bit more M&A activity.”

The overall level of reinsurance industry capital (both traditional and alternative) has been building more or less year-on-year in the past decade, progressing from US$378 billion in 2009 to US$516 billion in 2017, according to Aon Benfield Analytics. The total capital did drop slightly to US$496 billion in 2018, following the historic catastrophe losses of around US$150 billion in 2017. Coutts pointed out that while traditional capital shrunk by about US$20 million in 2018, the amount of alternative capital in the marketplace continued to grow.

“Despite [significant catastrophe] losses, alternative capital deployment had a continuing upward trend in 2018. The capital not only re-loaded, but it also increased. I think the reason for that was that a lot of market participants assumed that following the large losses in 2017 (Hurricanes Harvey, Irma and Maria) the market would see quite a significant improvement in the rating environment and pricing would go up,” Coutts commented. “That situation didn’t really materialize in 2018. Rates went up slightly but nowhere near to the extent that market participants would have hoped for.”

Following the 2017 catastrophe losses, there was also some loss creep. Loss estimates were made public and entities thought they knew their loss exposure, but over the course of 2018, some of those losses actually started to increase, especially relating to Hurricane Irma. Losses crept beyond what was projected, and some of the alternative capital ILS funds and catastrophe bonds performed worse than expected. As this type of scenario continues, there could be some sort of retrenchment and retraction in the volumes of alternative capital that are being issued in the marketplace, according to Coutts.

“The large impact of all of this alternative capital and extra competition is that, to date, we’ve seen relatively muted price rises following quite significant losses,” he added. “In 2018 and 2019, the January renewal rates have been relatively disappointing. Assuming we have an average level of catastrophe losses in 2019, I think we’re likely to see a stable outlook this year. We won’t have the same whole-market shift that we’ve seen in the past. If a line has a loss, there might be some rate improvement there, but, if not, we’ll probably continue to see some slight rate reductions. The issue we have is that for most lines, the pricing is approaching the cost of capital. There’s not much further rates can fall before some reinsurers start to make losses.

“It’s pretty clear now that any improvement in the rating environment is much more short-lived than it has been in the past, and excess capital can come in very quickly to dampen any price improvements that we see. I think that reflects a new structural reality for the reinsurance market. Alternative capital is now competing very strongly and very directly with traditional reinsurance capital, and so this limits the extent of any cyclical price changes we used to see following these large catastrophe events.

“I don’t think we’ve seen the end of the traditional reinsurance cycle. We will still see rate fluctuations post-losses, but I don’t think the market reaction will be to the same extent as it has been in the past. Market dynamics have certainly shifted and market participants will need to adapt to a new reality where you can’t just assume that you can pile in with loads more capital after a large loss and expect to get a very large rate increase.”