Reserving will continue to be a key debate in the reinsurance space as current release levels are “unsustainable” although reinsurers still remain mostly comfortably reserved, according to Morgan Stanley equity analysts.
Analysts commented in the firm’s latest market research report that most reinsurers are comfortably reserved, although with varying buffer levels – they show stable reserve releases to support earnings and offset soft market conditions.
However, if firms maintain current reserve practices, in the near-long term future, balance sheet stability will be jeopardised.
2016 reserve release levels remained high, according to analysts, due to continued low inflation seen last year.
Reserving philosophy varies greatly among the large European reinsurers, with Munich Re and Hannover Re reserving prudently, SCOR reserving to best estimate plus a margin, and Swiss Re reserving to best estimate: “We believe that the German reinsurers prefer to use reserve releases to smooth earnings every quarter, while Scor will use reserve releases only if necessary (i.e. a high nat cat quarter).
“Whereas we have seen reserve charges by some primary insurers in recent years (i.e. AIG, Zurich), all of the reinsurers under coverage have shown positive prior year development over the last 7 years,” analysts said.
And although global reinsurers still enjoy “comfortable” reserves, analysts deem the high release levels “unsustainable,” saying the quality of initial loss booking appears to have deteriorated in 2016, as seen by an increase in the paid/incurred ratio.
Property & Casualty is an area where reserving practices have been brought into question by Morgan’s equity analysts; “We believe that reserving in P&C has become more of a debate in the last two years, given that reserve releases made up over 20% of operating profit for the reinsurers in 2016.”
With profits on both the investment and underwriting side of the balance sheet increasingly hard to come by, it seems aggressive release reserves to boost profits in P&C lines of business are increasingly becoming a crutch used by the sector to shore up realities of declining or insufficient underwriting profitability.
Analysts warned that risks to reserving come from the possibility of increasing claims inflation, which has generally fallen well below long-term industry expectations of 2-4%.
Another risk to reinsurers ensuring they hold sufficient reserves is the low levels of major cat losses, which mean the industry haven’t been building the usual reserve cushion post a large re/insurance loss event.
Although the major global reinsures have stable reserve bases still, the trend of unsustainable levels of reliance on reserve releases continues to exist and intensify as the benign loss experience continues and rates consistently decline across the reinsurance space.
Morgan analysts said that given the current oversupply of capital, a large loss such as a $50-100 billion hurricane event, wouldn’t cut into the global excess capital supply enough to cause a pricing upturn
Instead, the analysts believe, a combination of “reserve deterioration, pressure on investment income, large cats, and unmodeled losses would need to happen before pricing is materially affected.”
Reinsurance demand could also be driven by agency model changes, the report said.
With emerging large-scale risks like cyber that could hit the market with heavy losses in coming years and continued reserve deterioration already occurring, changes to market conditions that would cause an upswing in the pricing cycle could be on the horizon.
Added to this are climate related events being forecast to intensify in frequency and severity, however, there are still massive protection gaps for these major risks, with some areas of the world being highly exposed but vastly underinsured, and it’s likely that these gaps will have to be addressed for demand to grow and the excess capital to be sufficiently put to use.
Until that point comes reinsurers will have to continue to manoeuvre carefully through the challenges of pricing declines, maintaining a disciplined and prudent approach to reserving and purchasing efficient protection for adverse developments.