The level of required risk- adjusted capital has increased faster than the level of traditional reinsurance capital despite capital levels having grown steadily until 2022, according to AM Best analysts.
This was due to a rise in underwriting risk experienced over the same period, as more frequent catastrophic events and uncertainty about social inflation generated dull underwriting margins throughout the industry, the credit rating agency pointed out.
AM Best calculates capital utilisation by examining required risk adjusted capital levels in comparison to available capital levels. Capital utilisation approximates how much of the available capital of the market is required to maintain risk-adjusted capitalization at the strongest BCAR of 25% at a 99.6% VaR (Value at Risk) level.
Additionally, it tracks how much capital depletion is needed to reduce BCAR to 10% at 99.6% VaR. This measure approximates the tolerance afforded to companies in extreme stress scenarios.
“At year-end 2022, traditional reinsurers’ capital utilisation sharply increased to 103% from 82%, driven by a 10.7% increase in required capital, which was compounded by the decreases in available capital previously noted,” analysts explain.
Adding: “While capital utilisation exceeding 100% indicates that risk-adjusted capitalization levels have dropped below the “strongest” measurement, AM Best expects this to reverse in the near term as some of the market’s unrealized losses are recouped in 2023.”
The agency noted that it has not had any rating actions related to various reinsurers’ balance sheet strength assessments in 2023, as much of the concerns focused around operating performance.
However, in the interim, if the market liquidates investments to pay for large claims, it would crystallise some of the capital stress currently viewed as short-term or transitory, it warned.
Required capital, as measured in BCAR at the VaR 99.6% level, can be broken down into eight separate risk factors: fixed-income securities, equity securities, interest rate, credit, net loss & loss adjustment expense (LAE) reserves, net premiums, business.
Including catastrophic with an additional covariance adjustment that reduces the total level of required capital, taking into account underlying correlations.
In 2022, the largest relative increase in risk, of 27.8%, relates to interest rate risk. This is not surprising, analysts noted, as PMLs (probable maximum losses) have increased by 9.5%, at the same time as fixed-income investments are down 6.7% year over year.
Adding: “Companies would be required to liquidate far more bonds and realise losses in the event of a shock loss. Furthermore, despite devaluations throughout the year, fixed-income securities risk is up 10.3%, and equity securities risk, 9.9%, driven by greater volatility in underlying assets, as well as further deployment of cash into new, higher-yielding assets.”
AM Best anticipates that, through the rest of 2023, some of the investment losses will dissipate, and capital will be generated through operating returns.
The agency’s projection includes a 6.2% increase in capital levels, augmented by a 10% decrease in required capital. The reduction in required capital is anticipated from a drop in PMLs, as reinsurers further distance themselves from lower-level property layers, analysts explain.
“Additionally, the economic recovery should help raise investment values and lower interest rate risk, which should result in an increase in available capital. How much capital will reenter the market outside of traditional underwriting earnings and investment gains is uncertain,” said AM Best.
“Established players have raised capital, but that is not strictly dedicated to reinsurance. New participants have been unable to raise capital despite strong business plans and management team support. The length of this hard market will likely depend on how quickly investor appetite changes for funding reinsurers.”
