According to a new report from AM Best, reinsurers must be able to meet their cost of capital to remain relevant and survive.
Having navigated five years of elevated property catastrophe activity, and amid rising social inflation, reinsurers have struggled to meet their cost of capital, which has increased during the period due in part to the greater volatility in return measures.
The industry’s return on capital remains stable, with a five-year average annual return of just over 4% for the period ended December 31, 2020.
AM Best noted that exacerbating the pressure on returns is the high level of capitalisation, with capital utilisation rates hovering around 80%, as evidenced by Best’s Capital Adequacy Ratio (BCAR) scores at the 99.6% Value at Risk (VaR) level.
This is well in excess of the 25% minimum needed to earn a Strongest BCAR assessment, according to the rating agency.
Although the industry’s cost of capital remains nebulous owing to the changing environment, it is likely closer to 10% or more, even with a risk-free rate near historical lows.
If interest rates rise quickly or significantly, the cost of capital will increase across the board, leaving underperforming reinsurers in a return versus cost of capital deficit that can’t be overcome without severe action, such as consolidation.
Reinsurers have been attempting to minimise return volatility through vertical diversification efforts that entail the use of a primary insurance platform, a reinsurer, and an affiliated third-party capital vehicle.
Additionally, many reinsurers are avoiding the “working layers” of catastrophe reinsurance programs and curtailing their participation in aggregate covers, which have been hit hard in recent years.
Reinsurers have also tried to diminish return volatility by diversifying horizontally through the geographic spread of risk, as well as line of business diversification.
Many reinsurers raised capital as the pandemic spread in 2020, initially to ensure liquidity and then in 2021 to take advantage of market opportunities.
Most reinsurers have deployed significant amounts of capital, writing better-priced business, while a few returned some of the capital that they could not deploy rationally.
Additionally, several reinsurers issued debt at very low interest rates to replace existing debentures with higher coupons that have matured, or will mature, in the near term.
AM Best believes that reinsurance pricing must continue to harden to combat the underwriting issues arising from higher climate-related property catastrophe losses, social inflation, anemic investment returns, and an uncertain economic outlook.
Ideally, rates should rise more quickly than underlying loss cost inflation, to ensure progress toward earning an acceptable cost of capital, thereby increasing the chances for individual companies to survive and prosper.
The rating agency has expressed the importance of the next few years within the reinsurance industry as challenges and opportunities come to bear.
The net income and return on capital will be challenged by the declining contribution of reserve releases to profits, social inflation, property loss cost inflation, low investment yields, climate trends resulting in heightened property catastrophe activity, and a still fragile global economy that is just starting to recover from a global shutdown.
These challenges will be offset by sustained increases in reinsurance rates, growing demand for reinsurance capacity, more careful risk selection (including tightened terms and conditions), and more efficient capital allocation. In many ways, the challenges are driving the opportunities as reinsurers manage their way through an uncertain world.
Ahead of the January 1st renewals, AM Best has maintained its stable outlook on the global reinsurance sector, as it sees heightened demand for protection, continued positive price momentum and a disciplined underwriting environment has seen ratings agency.
