Reinsurers Hope Profitability Party Will Last – But All Good Things Must End

Executive summary: Fitch Ratings is projecting reinsurer returns on equity of 14% in 2023 and 2024, results that reflect a reinsurance environment that has effectively returned to the pre-soft market state of providing capital protection rather than earnings protection for primary insurers. Here, Senior Director Brian Schneider reviews conditions in the current hard market, which Fitch expects to persist into 2024.

Reinsurers are hoping the profitability party will last as reinsurance pricing and structural changes to tighten terms and conditions have increased returns to above the cost of capital for the first time in a decade.

As with previous market cycles, however, all good things must come to an end as better underwriting returns will eventually attract more capital and lead to a softening of the market. But for now, the reinsurance market is enjoying the rewards.

Fitch Ratings recently revised its global reinsurance outlook to “improving” from “neutral” to reflect the sector’s underlying financial performance improvement. High price discipline driving a hard market environment, rising reinvestment yields and strong demand for reinsurance protection are likely to support earnings.

The favorable reinsurance market conditions of selective supply and growing demand continues, creating an enduring environment for improved margins into 2024. Reinsurers that have the capacity to provide coverage stand to benefit the most, including from a reinsurance-led hard market in property.

Near-term price increases continue to exceed loss-cost trends. Fitch expects the headwinds linked to the high inflation and rising interest rate environment to ease, while the negative effect of climate change on natural catastrophe claims should be priced in adequately.

Several well-positioned companies are leaning heavily into the best reinsurance underwriting environment in decades, with some acquiring additional platforms to complement their sizable organic growth opportunities. This should add further discipline to the market as more marginal capacity exits.

Additionally, a renewed interest from institutional investors on the back of better expected returns is leading to strong net inflows into insurance-linked securities (ILS) capital. More capacity from traditional and alternative sources will lead to a gradual market softening over time, potentially in 2025.

Rates Surge; Property Market Hard

Fitch expects reinsurance market hardening to persist into 2024 at the January renewals and beyond, even in the absence of sizable catastrophe losses. However, pricing and terms should be more stable than in 2023 as rate adequacy has generally been reached, following several rounds of market hardening that began in 2018. This sustained push is driven by the continued supply/demand imbalance as reinsurers hold firm to maintaining underwriting discipline, even with higher interest rates.

Net income ROE in 2023 and 2024 is expected to be about 14%, which would be above the cost of capital of 8-10% for the first time since 2014. This positive result reflects a reinsurance environment that has effectively returned to the pre-soft market state of providing capital protection for cedents, rather than earnings protection, with volatility moving back to primary insurers.

Reinsurance demand remains strong as primary insurers contend with increased risk and higher total insured values as a result of inflation. However, cedents are retaining more risk as the capacity for low layers that attach at a higher frequency of less than a one-in-10-year period has been nearly eliminated and coverage moved almost exclusively to per-event occurrence protection, with limited aggregate cover treaties offered.

Fitch views it as unlikely that there will be any sizable new reinsurance capacity added at Jan. 1, 2024 as reinsurers have become much more selective. This is particularly the case in property due to elevated catastrophes, notably with increased secondary perils, where modeling is less robust. Several companies partially or completely withdrew from the property-catastrophe market, although some increased capacity to take advantage of the hard market.

Terms and conditions saw structural changes in 2023 that serve to benefit reinsurers’ risk/reward profile and are likely to last longer than the near-term rate impact. Cedents experienced substantially higher retentions, reduced limits, increased attachment points, limited reinstatements, as well as non-concurrent pricing and policy terms varying by reinsurer and layer. Coverage also narrowed with reduced hours clauses, sublimits on perils and, in some treaties, all perils revised to named storm-only coverage on lower layers.

Reinsurance Consolidation and Increased Concentration

The reinsurance market is experiencing greater industry concentration and consolidation of business. This reflects the retrenchment of several reinsurers, as many investors expressed concern with the volatility of reinsurance business, especially on property exposures given recent heightened catastrophe losses and climate change risk.

At the same time, the favorable reinsurance market conditions that are partly the result of selective supply have pushed several reinsurers to lean heavily into the market and significantly increase business. This consolidation of business should help the reinsurance industry to maintain its discipline as a result of reduced competition.

A good example of consolidation is RenaissanceRe Holdings Ltd.’s expected fourth-quarter 2023 acquisition of American International Group Inc.’s (AIG) treaty reinsurance platform for $3 billion. This includes Validus Reinsurance Ltd., AlphaCat Managers Ltd. and the renewal rights for Talbot’s assumed treaty reinsurance business. Validus, which was established in 2005, was purchased by AIG in 2018.

Fitch views the Validus acquisition positively as it boosts RenaissanceRe’s leading position in the property/casualty and specialty traditional and alternative reinsurance market. The transaction adds sizable reinsurance business during a favorable market environment. Integration risk should be limited given the similar reinsurance lines of business written by RenaissanceRe and Validus.

Another recent strategic reinsurance acquisition is Berkshire Hathaway’s purchase of Alleghany Corp. in October 2022 for $11.6 billion. Alleghany continues to operate as an independent subsidiary of Berkshire. This includes the company’s largest operating subsidiary, TransRe, a global reinsurer that uses the broker distribution channel, which complements the direct channel of Berkshire Hathaway’s General Reinsurance Corp.

AXIS Capital Holdings Ltd. and AXA XL are examples of companies that significantly lowered property-catastrophe reinsurance exposure to reduce overall volatility. Both companies were also reported to have considered selling their sizable but underperforming reinsurance operations. However, they each ultimately chose not to sell and instead repositioned their reinsurance underwriting portfolios to improve performance.

Alternative Capital Supply Grows

ILS funds have been raising capital in 2023 as returns in the sector have become increasingly attractive, with particularly strong catastrophe bond issuance. Fitch expects favorable conditions to lead to continued growth in the alternative reinsurance capital market for the rest of 2023.

In conjunction with significantly higher traditional reinsurance market pricing, the ILS market has experienced a favorable pricing environment that has made investing in catastrophe risk more attractive following years of loss events. Higher spread levels relative to expected losses is driving potential return improvement and leading to rising investor interest in putting capital to work in both reinsurance- and retrocession-focused deals.

The catastrophe bond market experienced an acceleration of issuance, setting a record of about $10 billion in first-half 2023, with a number of new sponsors using the capital markets for additional sources of reinsurance capacity. Capital availability from investors in 2023 has led to modest spread compression for new issue catastrophe bonds relative to the winter of 2022, a favorable outcome for those sponsors that seek to diversify their sources of reinsurance capacity.

Several deals have upsized in recent months and priced near the bottom of initial ranges, highlighting investor demand for the reinsurance investments. Fitch expects the heightened issuance activity in the catastrophe bond market to continue in the second half of 2023 and set a record for 2023.

This article first was published in Insurance Journal’s sister publication, Carrier Management.

Topics Reinsurance