What AM Best Says
AM Best Revises Global Reinsurance Segment Outlook

• February 2019
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AM Best has revised its outlook for the global reinsurance segment to Stable from Negative. This change primarily reflects a pricing environment in the global non-life reinsurance segment that has stabilized—albeit currently at levels still below long-term adequacy—and ongoing stability in the global life reinsurance segment. Although the operating and competitive landscape of these two major reinsurance business segments is distinct, the diversification benefits the global reinsurance segment from an overall earnings perspective.

Global Non-Life Reinsurance

In the face of a persistently competitive market environment, non-life reinsurance pricing appears to have settled at the bottom of the cycle for the near future. Significant factors supporting the revision of our outlook are listed below:

• The belief that alternative third-party capital will hold the line on future return expectations following the catastrophe losses incurred in 2017 and 2018.
• A decline in capital consumption and earnings volatility caused by tail events, due in part to the increased utilization of third-party capital in retro programs, and the growing alignment between traditional and third-party capital.
• A rising interest rate environment, particularly in the U.S., which could lead to alternative investment opportunities for third-party capital—rising interest rates could cause mark-to-market losses for bond portfolios, but investment incomes could increase for reinsurers who have managed their duration profile prudently.
• A renewed emphasis on underwriting discipline driven by potential loss cost inflation, coupled with lower loss reserve redundancies.
• Ongoing U.S. economic growth, greater use of reinsurance by cedents, new risk transfer opportunities, and M&A all providing greater growth opportunities.

That the glory days of a robust non-life pricing environment may not return is clear. Rates have stabilized, as the industry was reminded again in 2017 that almost $150 billion of capital can disappear over a very short period of time. What's also clear is that property catastrophe pricing is still being driven by the availability of alternative third-party capital and is not as heavily influenced by the traditional reinsurance companies. This is an important distinction as regards current market dynamics, since alternative capital is generally more efficient due to lower cost of capital dynamics. However, traditional capacity has become more closely aligned with alternative capital through joint ventures, retrocession, and direct ownership, which should serve to more closely align return objectives for the market overall.

Although alternative third-party capital remains disruptive due to pricing, it also represents a benefit in the form of stabilized earnings of rated balance sheets due to tail risk being assumed by this capital. The catastrophic events of 2017 constituted the first significant test of alternative capital use, which has led to both an affirmation of the alternative capital owners' persistency as well as the re-evaluation of the return requirements and governance of the structures providing alternative reinsurance capacity. A decline in earnings and capital volatility has ultimately lowered the return requirements of investors of traditional reinsurance companies. The decline in volatility has favorably impacted the average cost of capital of reinsurers. Long-term return on equity measures in the 8% to 10% range appear to represent a reasonable risk-adjusted return on equity, as evidenced by equity trading multiples and catastrophic loss events experienced in 2017 and 2018, which are characterized as earnings-only events for the industry. The growth of alternative third-party capital capacity is expected to continue, but the pace is expected to slow following the frequency and severity of loss events in 2017 and 2018, owing to the stable but relatively anemic pricing improvement. Also, the industry is digesting the recent disputes around collateral release before reinsurance recoverables are settled, which causes a significant increase in credit risk to policyholders. The longer-than-anticipated claims settlement loss tail associated with some catastrophe losses experienced in 2017, particularly hurricanes Irma and Maria, has led both investors and capacity users to pause and re-assess the changes needed in underlying agreements. These changes may result in a more measured use of alternative capital structures than currently exists.

Demand for non-life reinsurance is expected to increase this year due primarily to the return of U.S. economic growth and, to a lesser extent, global growth, coupled with benefits stemming from U.S. federal tax reform. These factors should provide opportunities for organic growth and improved utilization of existing excess capacity, which should improve long-term risk pricing. Similarly, an increase in reinsurance utilization resulting from primary companies' recent loss experience may increase reinsurance demand as well. Last, a potential increase in demand from government risk pools such as the National Flood Insurance Plan in the U.S., as well as opportunities in cyber, mortgage insurance and reinsurance, and other emerging risks, should allow for greater utilization of available market capacity. These factors, taken in aggregate, should help attenuate the long-term imbalance between the reinsurance supply and demand that has caused significant pressure on pricing over the last decade.

The non-life reinsurance business model will continue to evolve as traditional companies embrace more efficient forms of capital, by retroceding risk, particularly tail risk, and aligning risk with the proper form of capital, while expanding product and distribution capabilities. Reinsurers who can accommodate alternative capital will thereby enhance their relevance with clients and investors and garner the ability to earn low-risk, fee-based income in the process.

Global Life Reinsurance

Five large carriers, accounting for the vast majority of assumed business, dominate the global life reinsurance market. While almost all of the largest carriers write both life and non-life reinsurance business, life reinsurance comprises at least 40% of gross premium written. Moreover, the U.S. accounts for approximately one half of global life reinsurance premiums. The global life reinsurance segment has been a source of stability to the overall global reinsurance market for the past several years, the primary factors being:

• Defensible market positions of established participants, which create high barriers to entry.
• Demonstrated earnings stability due to a diversified product portfolio that consists of interest sensitive products, longevity and mortality blocks, along with health-related products.
• Growth opportunities due to emerging markets and Solvency II regulations
• Active pipeline of life, health and annuity blocks driven by potential opportunities created due to a variety of factors including aging demographics and demand for longevity risks.

In addition, the Stable outlook is a reflection of life reinsurance companies' robust capital position when measured in terms of risk-adjusted capitalization relative to their liabilities. Companies have looked to optimize their corporate structure to minimize tax liabilities resulting from due to headwinds created by the U.S. Tax Cuts and Jobs Act. AM Best has recently observed a trend of some reinsurers implementing broad based rate increases in some instances due to deterioration in their books of business, which partially counters the stabilizing factors. Some of this deterioration can be traced back to the late 1990s and early 2000s, a period when some carriers were overly aggressive on mortality improvements. In addition, low cession rates, despite an uptick in recent years, have led reinsurers to seek alternative sources of revenue such as interest-sensitive lines.

Evolving Landscape Is Manageable, But Not Without Challenges

Further consolidation in the global reinsurance segment is the likely result of the need for diversification and scale, and AM Best expects that M&A will continue, which, if done prudently, should help improve the efficiency of the market's overall capacity and lead to greater operational discipline. However, AM Best is concerned that M&A poses risk to the combined enterprise and will thus maintain its conservative opinion regarding M&A as it can be utilized as a veil for ailing franchises.

Climate change remains an ever-present threat, especially for reinsurers who assume severity risks across the globe. On November 23, the Trump Administration issued the Fourth National Climate Assessment, which outlines the impact of climate change and the new risks and vulnerabilities it creates in communities throughout the country. Although U.S.-centric, the assessment's findings echo numerous reports by global organizations such as the World Trade Organization and the United Nations Intergovernmental Panel on Climate Change. Given the experience of the recent past, climate change will remain a significant challenge for the entire reinsurance industry for years to come. Our view of what a strong reinsurance company is remains the same: It is a company with a robust risk-adjusted balance sheet that can be relevant to and easily access alternative capital; that generates sustainable operating returns from diversified reinsurance business portfolios; has prudent investment management capabilities; and embraces innovation. Reinsurers who lack these characteristics will struggle to remain relevant to the industry, maintain the support of shareholders, and preserve their independence. 

This Best's Market Segment Report is available at http://www3.ambest.com/bestweek/bestweekreports.aspx?RT=sr.