Industry must address depressed investment yields’ impact on profitability

A topic that needs to be given more attention when considering profitability in the current reinsurance market is the impact of depressed investment yields.

This is the view of Daniel Vestergren, chair of international, Hiscox Re & ILS, speaking to Intelligent Insurer.

It has been widely reported that poor underwriting results over the last few years have contributed to the upward rate momentum currently seen in selected reinsurance markets. Rate rises are expected to continue, fuelled by an increased cost of capital driven by impaired and trapped capital in the retro market following COVID-19.

Most reinsurers have been tougher in the way they assess the risk they’re running—this is offsetting nominal rate increases and adds to the pressure on expected returns. Typhoon risk in Japan is a prime example, California wildfire another.

However, according to Vestergren, an important factor that is being left out of the equation is the detrimental impact the depressed investment yield has on bottom line profitability.

“This should really be the thing that underpins an improved rating environment across all markets, including those that are less capital-consumptive,” he said.

“Assume the average reinsurer has a 1.5 to 3.5 times multiple of invested assets to shareholders’ equity depending on line of business composition.

“The treasury yield in the US has dropped about 150 basis points since the start of the year to a level close to zero.

“Using those multiples, this effect alone will result in a return on equity drop of 2.25 to 5.25 percentage points for most carriers. Looking at the yield curve, this is not a short-term change—it’s more likely to be a paradigm shift for years to come.

“Moreover, with equity markets on close to all-time high levels, the investment outlook on risk assets is bleak as well,” he explained.

Vestergren believes it’s essential to return to a more rate-adequate and sustainable environment over the long term to offset all the effects that are threatening the profitability of the industry.

“This is not a short-term change—it’s more likely to be a paradigm shift for years to come.” Daniel Vestergren, Hiscox Re & ILS

Causes for optimism
The last few years have been tough for the entire market but Vestergren sees reasons to be optimistic.

“Stripping COVID-19 out, most lines are performing close to our expectations for 2020 so far,” he said.

“Although we have been spared large natural catastrophes in the year to-date, attrition from smaller cats and manmade losses have put unnecessary pressure on bottom line performance. There’s certainly not been any shortage of frequency—the hurricane season is already into the Greek alphabet for naming storms.”

Hiscox Re & ILS is looking closely at how it is deploying capital going into 2021 and will focus more on protecting its clients’ capital positions, as opposed to earnings, to improve the attritional loss ratio going forward.

“If you overlay COVID-19, it’s putting the industry under water yet again,” Vestergren said. “However, there’s a lot of uncertainty in how the industry is reserving this event. I doubt the reinsurance industry will have any more clarity before the second half of 2021.

“It’s not all doom and gloom, though. Conditions are improving across most lines,” he added.

“We’ve put double-digit risk-adjusted rate increase on the books in 2020 across our reinsurance lines with tighter terms and conditions. This is something to build on going into 2021.”

As it looks to build performance, Hiscox Re + ILS is considering several main themes: a return to a rate-adequate and sustainable environment over the long term, a focus on core lines of business and products, and managing attrition.

“For example, aggregate products became increasingly prevalent through the soft market cycle,” he said.

“We are questioning the rate adequacy of those products and will continue to scrutinise capacity deployed in this space.

“We will review low rate-on-line business where we run a negative capital arbitrage as retro costs are going up and we’re not being compensated enough for the tail coverage we’re providing, and the payback period is unsustainable in the event of a loss,” he said.

“The industry needs to be better at providing valuation certainty to its investors.”

Future focus
Another area of focus is stricter terms and conditions. This includes tightening up things such as hours clauses, but also breaking out coverages.

“Separate policies should be sold for terror, cyber and pandemic risks to name a few,” Vestergren said.

“The property cat market should not act as a back-stop for all risks; it’s not healthy and not sustainable.

“We’re starting to see named natural perils coverage across some of our property lines. That’s a trend that’s likely to continue as the industry needs to be better at providing valuation certainty to its investors.”

The company will also continue to focus on climate variability trends and how this changes the way it is accepting climate perils on its balance sheet and how it adequately prices for evolving perils such as wildfire.

Another key area of focus is to build out its parametric offering to address the protection gap and increase the amount of capacity the company can deploy for the same amount of capital.

“This would unlock a lot of capacity for the cyber market, in particular, where there’s currently a capacity crunch—by, for example, selling cloud outage policies to cloud providers,” he said.

“However, it would also greatly benefit the traditional nat cat market—especially for climate perils such as wildfire where capacity is likely to be under increased pressure going forward. “The hardening market has focused the minds of reinsurers on some of these issues and how central they will be to profitability in the years to come.”

Discussing other opportunities, Vestergren noted that in the past 12 months Hiscox has been strategically growing its global agriculture reinsurance presence.

“We have established ourselves as leaders in the agriculture retro market, providing pricing and lead capacity,” he said.

“We see a specific opportunity in China with the creation of China Agriculture Re.”

Outside the core agriculture markets—the US, Canada, India and China—Hiscox is actively targeting business in the emerging markets and developing economies.

“We are particularly happy about our increased engagement and support on multinational pools,” Vestergren added.

“We believe the private re/insurance sector has an important role in improving global rural resilience, and will look to continue to increase our support of parametric risk transfer programmes—a cost-efficient solution for all parties involved.

“We are excited about private-public partnerships beyond the scope of just agriculture re/insurance. We believe the current COVID-19 crisis has heightened global awareness and importance of disaster risk management.

“We see an opportunity to partner with the public sector to support sovereign and regional catastrophe risk transfer schemes,” he concluded.