S&P Isn’t Budging on Reinsurance Outlook

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Taoufik Gharib, senior director and lead analyst, S&P Global Ratings, and Johannes Bender, director and lead analyst, provided their take on sector profit drivers, capital positions and the impacts of broader economic conditions during a virtual event just before the start of the Rendez-Vous de Septembre gathering in Monte Carlo. For most of the session, the two analysts discussed the themes of a report published by the rating agency two days earlier, titled “Is The Global Reinsurance Sector About To Turn A Corner?”

“Our answer is at this stage, not yet,” said Bender, answering the question posed by the report title about the possible turning point for the sector, and a related question about the prospect of S&P reverting back to a stable outlook posed by a webinar attendee.

While pricing improvements for most reinsurance lines, together with a “full-on hard market environment” for property-catastrophe reinsurance, suggest that the “global reinsurance sector could finally be facing a turnround,” the report said a series of headwinds could prevent it. S&P expects underwriting profitability will improve in 2022-2023, but “the combined impact of higher frequency and more severe natural catastrophes, untamed inflation across the world, mark-to-market investment losses eroding capitalization, and the Russia-Ukraine conflict all threaten the reinsurance sector.”

Gharib said that S&P revised the credit outlook to negative from stable back in May 2020 because of the historically weak underwriting performance from 2017-2019, and because of the expectation that the pandemic-created losses combined with volatile capital markets and lower investment returns would prevent the sector from meeting its earnings expectations at that time.

“Fast forward to today, we still believe reinsurers will continue to struggle to sustainably earn their cost of capital due to [the] potential [for] high natural catastrophe losses, despite the fact that the first six months has been somewhat benign…We’re still in the middle of the North Atlantic hurricane season. In addition, the capital market volatility and increasing cost of capital and high inflation in this year and next year…are the factors that actually influenced our view to keep the sector still on negative outlook going forward,” he said.

In the past, S&P analysts have explained that the cost of capital is the cost of raising additional capital. From a debt perspective, this is easier to quantify as this is the interest rate expected by investors to raise debt. From an equity perspective, this is the theoretical return expected by investors in exchange for the risk in investing in a company. (Related article: Reinsurers’ Profits Risk Falling Below Cost of Capital: S&P)
Elsewhere, in a 2018 Guy Carpenter report, for example, the cost of capital is more simply defined as a measure of what return the company needs in order to pay both its debt interest and provide returns to shareholders.

The struggle to “sustainably earn the cost of capital” was the main theme that Gharib referenced repeatedly throughout the one-hour event. At one point, he displayed a graph that is also in the report showing the weighted average cost of capital for each year between 2005 and 2022 hovering in the 6-9 percent range, plotted with reinsurers’ return on capital (for the trailing 12 months each year) wildly swinging from one year to the next. Return on capital, which was shown at a high mark of 18 percent for 2007, reached a low near 2 percent in 2018—both well outside of the 6-9 percent cost of capital figures.

“The industry has a poor track record when it comes to earning its cost of capital. Reinsurers failed to pass the hurdle in the past five years, except in 2019,” Gharib said, referring to the graph. “2022 looks to continue this trend” of returns falling below the cost of capital, he said. (In the only recent year in which reinsurers did earn their cost of capital, 2019, the graph shows a 9 percent return for reinsurers against a weighted average cost of capital figure shown just above 6 percent.)

“Although underwriting performance in property/casualty and life reinsurance is improving in our base case [forecast] in 2022 and 2023, we believe the sector still needs to demonstrate its ability to sustainably earn its cost of capital before we could potentially revise our outlook to stable from negative,” he said.

At various points during the webinar, the analysts referred to the overall capital position of reinsurers being a “pillar of strength” for the sector. Even though mark-to-market investment losses will mean a decline in capital in 2022, “we believe that capital adequacy remains a strength and that companies can recover that,” Bender said. “At the same time, it looks like ILS capacity is stable and remains a part of the game,” he added.

The session’s moderator, Simon Ashworth, chief analytical officer, was motivated to answer a question that did not come during the virtual event but one that he says is posed to S&P regularly—”Why are we zeroing in so much on profitability?”

“To be frank, for the highest rating levels which we see across the reinsurance sector, capital is almost a given, and really very much what differentiates relative credit risk is indeed profitability,” he stated.

On the bright side, for 2022 and 2023, S&P forecasts underwriting profitability for reinsurers as a base case scenario, putting the sector combined ratio in the 95-98 range for both years. “Despite the performance over the past five years,” in which combined ratio for the top 21 global reinsurers averaged 102.3, “the underlying metrics have improved in the past 18 months”—owing to favorable reinsurance pricing, Gharib said, reporting that the average combined ratio for the same group of reinsurers fell to 96.5 in 2021 and the low nineties in the first half of 2022.

In addition to catastrophe loss impacts, the volatile results for the past five years included $25 billion in pandemic losses from P/C and life in the past two-and-a-half years for the group of 21 reinsurers S&P analyzed, Gharib said. They also reported $1.4 billion of incurred-but-not-reported losses related to the Russia-Ukraine conflict in the first six months of 2022, he said, noting that the figure did not include a £1.1 billion provision announced by Lloyd’s on the same day of the webinar, bringing the total to about $2.7 billion.

For 2022, S&P forecasts an ROE between 3 and 5 percent, given the expectation that realized and unrealized investment losses will have a big impact on the result, Gharib said. But S&P sees ROEs improving to somewhere in the 7-9 percent range in 2023.

The go-forward combined ratio forecasts include a natural catastrophe load of 8-10 points, Gharib noted.

At one point, when an audience member asked the analysts whether climate change is a threat or opportunity for the reinsurance sector, Bender gave a summary of the impact of natural catastrophes on ROEs in recent years. “Since 2017, reinsurance companies have budgeted significantly less natural catastrophe losses than actually happened, he said. “That cost about 2.5 percentage points, on average, every year in these years,” he said referring to 2017-2021. “That also means that if the companies would have met their budget, the ROE would’ve been 2.5 percent higher every year, which is obviously quite big, big numbers” in dollar terms, he said.

“When it comes to pricing, the reinsurance renewals have becoming an increasingly dynamic process in recent years with unique factors affecting most lines of business,” Gharib said. Prop-cat reinsurance rates have been increasing since 2018, given the elevated catastrophe loss exacerbated by CPI inflation and supply chain issues. While reinsurers are getting required price increases, rate adequacy, particularly in property-catastrophe, is questionable reflecting the divergence of strategies among reinsurers regarding this line,” he said.

Both Gharib and Bender referenced an earlier report in which S&P observed that reinsurer strategies are split almost right down the middle, with half increasing their natural catastrophe exposures and the other half reducing them, some exiting entirely. (See related article: 50-50 Split: Reinsurers Feel Strongly Both Ways About Catastrophe Risk.)

Inflation was a much-discussed topic at the webinar, as it has been in other forums. “Some companies are declaring that inflationary developments have not been fully reflected…in recent price increases, although, in particular, in the natural catastrophe business, the price increases have been quite significant,” Bender said, wondering aloud whether increasing cat exposure or cutting back will ultimately prove to be the right strategy.

“A few players have been quite transparent in the renewals [about] what price has been after the impact on inflation. Some even big market players have indicated that, after inflation, there was almost zero rate adequacy improvements in the last renewal,” he said.

Gharib said “whether it’s social or CPI, inflation risk is increasing for reinsurers, as it elevates claims costs and potentially affects underwriting results from current and prior accident years, which could overshadow any benefit from high investment yield” going forward,

The impact of social inflation already has been visible in global reinsurers’ reserve development, which remained favorable, but [reserve] releases declined to about 2-3 percent in 2020 and 2021 from about 5 percent in 2017 and 2018, Gharib reported.

Because of social inflation coupled with our base case assumptions on CPI inflation, S&P expects the benefit from reserve releases to further moderate in this year and next to 1 or 2 percent.

He also said that S&P Global Ratings economists expect inflation to moderate in 2023 and revert to normal levels in 2024.

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