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14 December 2016 Insurance

Reinsurers face a tough year in 2017

AM Best, Fitch and Moody’s all hold a negative outlook for the global reinsurance sector.

The reinsurance industry faced pricing pressure in 2016 while a low interest rate environment squeezed investment yields. The sector was, however, able to offset these pressures through reserve releases due to the absence of large catastrophe losses.

AM Best sees continued market challenges hindering the potential for positive rating actions over time, and adds that this trend may eventually translate into negative rating pressures.

In its December briefing the ratings agency stated that the strain on profitability is evident in reduced risk-adjusted returns with market headwinds at this point, presenting significant longer-term challenges.

“Recent indications of a market bottoming are slowly emerging, but the overall operating environment remains negative, which is concerning,” said Robert DeRose, senior director at AM Best.

Negative factors such as low rates, broader terms and conditions, the unsustainable flow of net favourable loss development and anaemic investment yields will continue to adversely impact risk-adjusted returns for reinsurers.

The low interest rate environment has driven investors into the reinsurance business in their search for acceptable returns. This has contributed to overcapacity particularly in property/casualty and to the current soft market.

Alternative capital now comprises approximately 20 percent of the dedicated global reinsurance market capacity, according to AM Best. This percentage has been steadily growing year over year, underscoring why cycle management has been a key strategy for organisations possessing the capability to move between primary and reinsurance platforms, the rating agency said.

The current strength of reinsurers’ balance sheets may erode over time as earnings come under increased pressure, favourable reserve development wanes, earnings grow more volatile, and the ability to earn back losses following events is prolonged by the instantaneous inflow of alternative capacity.

“These issues have placed unrelenting pressure on underwriting discipline, forcing insurers to exercise restraint or risk long-term viability,” DeRose says.

In AM Best’s view, companies with diverse business portfolios, advanced distribution capabilities and broad geographic scope are better-positioned to withstand the pressures in this difficult operating environment and have greater ability to target profitable opportunities as they arise.

Moody’s expects underwriting profitability in the reinsurance sector to continue to decline, albeit more slowly than in previous years, due to lower price reductions, it said in a December statement.

Moody’s does, however, also see some improvements in demand for reinsurance. While demand is still tepid, there has been a slight uptick in 2015 and 2016, according to the agency. This has been driven by low reinsurance prices and primary insurance companies' desire to use reinsurance as a tool to limit earnings volatility.

Nevertheless, Fitch warns that further profit declines in underwriting and investments could result in negative rating actions. The agency’s base case forecast assumes major losses returning to the long-term historical average, highlighting the current sensitivity of the sector’s earnings due to thinning underwriting margins.

Fitch expects pricing conditions to remain challenging during 2017. In addition, Fitch believes that a return of major loss costs to the historical average would have only a limited effect on improving prices.

The reinsurance sector’s calendar-year combined ratio is set to deteriorate to 99.2 percent in 2017 compared to a 2016 forecast of 94.2 percent and 86.8 percent in 2015, according to Fitch.

Profits at several companies have diminished notably since 2012 to levels that could, if sustained, lower their respective financial strength. It is highly likely that a further deterioration in the profit metrics of those companies could result in rating downgrades, or their ratings being moved to ‘negative outlooks’.

Fitch expects the majority of reinsurers to report lower profitability in 2017 compared to forecast 2016 results, driven by falling reinsurance prices and declining investment returns, especially on reinvested assets.

The quality of earnings is expected to deteriorate as underwriting margins and investment returns continue to fall. Earnings assessments will give greater consideration to operating ratios (combined ratio, less the ratio of investment income to net earned premium) to assess reliance on investment returns. Smaller companies with limited diversification are at greatest risk of negative rating action. Conversely, major Tier 1 diversified reinsurers should be among the winners of the changing reinsurance landscape.

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