Reinsurers are living on borrowed time, with losses inevitable: S&P

S&P Global Ratings expects the reinsurance sector’s financial performance to deteriorate in the coming quarters. Nevertheless, an accumulated capital cushion may keep it going—at least for a while.

Returns on capital delivered by reinsurers have been declining since 2005, and while the soft market is likely to endure due to excess available capital, investment returns are also expected to stay under pressure for some time as interest rates are set to remain at historically low levels, the rating agency said.

As a result, return on capital may fall below the industry’s cost of capital in 2016 and 2017, David Masters, director insurance ratings at S&P Global Ratings, suggested at a pre-Monte Carlo event. Even so, investors are likely to “begrudgingly” remain invested in the sector due to a lack of better alternatives in their search for yield, he said.

The ratings agency forecasts an average return on capital of between 5.5 percent and 7.5 percent in 2016 and 2017 for the sector, compared to a cost of capital floor of around 6 percent.

The industry’s combined ratio is expected to rise to between 97 percent and 102 percent in 2016 and to between 100 percent and 104 percent in 2017, according to S&P Global Ratings. At the same time, the sector’s return on equity is set to fall to between 7 percent and 9 percent in both years.

It could get worse if tougher capital requirements or expensive cat events further impact return on equity, Masters said.

Pricing pressure has begun to impact reinsurers’ financial results, and non-proportional reinsurers are particularly affected as their pricing pressure is higher compared to proportional reinsurers, Dennis Sugrue, senior director insurance ratings, said.

In addition, investment returns are set to fall further, and even if interest rates are lifted, it will take time to have an effect on the sector’s investment returns, he noted.

“I don’t envy the challenges they’ve got ahead,” Sugrue said.

On a positive note, reinsurers have built up a capital buffer on the back of a generally benign catastrophe experience and good bottom line profitability, Masters noted.

An excess of capital in the sector would allow reinsurers to take more risk in their investments in search for higher returns. But companies’ investment strategies are unlikely to change substantially as higher risk could create volatility in their solvency ratios, Lotfi Elbarhdadi, senior director insurance ratings, suggested.

Instead, return on investment is likely to decline to around 2.1 percent and 1.9 percent in 2016 and 2017 respectively, compared to 2.5 percent in 2015. The sector’s return on investment has declined by 60 basis points since 2011, according to S&P Global Ratings.

To offset a decline of 10 basis points in investment return, reinsurers need to lower their combined ratio by 20 basis points, which is hard to achieve, Elbarhdadi explained.

Overall, small and more concentrated reinsurers may find it difficult to operate in this environment, while larger, diversified reinsurers such as Munich Re or Swiss Re are better equipped and have been gaining market share recently. The ratings agency expects this gulf to widen further, adding pressure on the business models of smaller players.