Deficient reserves – the next big reinsurance risk?

09 February 2017

With growing fears that the (re)insurance sector is in a danger zone, it is time for cedents to consider buying protective covers.

There’s always conjecture about when (re)insurance market cycles will change, and the sort of events that will make them do so.

The focus tends to be on a major catastrophe or series of disasters. But historically, another area has been even more important to insurers’ balance sheets: reserving.

The implications of reserving for the insurance sector can’t be overestimated, says a new JLT Re report, ‘Enough in Reserve?’.

Deficient reserves have been a major cause of financial impairment for insurers in the past. They’ve accounted for 45 per cent of all impairments since 1969, according to our report. This compares to just 7 per cent for the catastrophe losses that tend to dominate market attention.

Danger zone

Although traditionally a bane of insurers’ existence, deficient reserves have become a boon in recent years. Carriers have released redundant reserves into earnings, compensating for record low investment yields and elevated catastrophe losses.

Yet after more than a decade of favourable development, there are growing fears that the sector is in a danger zone. Reserves are being released faster than accident-year experience would suggest is wise, which is flattering calendar-year profitability.

According to ‘Enough in Reserve?’ today’s situation is eerily similar to1998-2000 – though less pronounced – which led to the last liability crisis. The sector is emerging from several years of positive underwriting results, and of low loss inflation and frequency.

JLT Re analysed quarterly calendar-year reserve developments since 1998 for the top 30 global (re)insurance companies, and compared them to accident-year loss trends, pricing and previous cycles.

David Flandro, Global Head of Analytics at JLT Re, explains: “Our research revealed that net sector deficiencies are probably now closer to adversely affecting the sector’s income than any time since the early 2000s.”

We also found that quarterly calendar-year reserve movements have been slow to respond to cyclical trends. Flandro explains: “Carriers released reserves on average for eight consecutive quarters in 1999 and 2000, even though accident years 1998 and 1999 were developing unfavourably by the year 2000.”

The sector experienced extreme danger during the late 1990s, and the result was a period of strengthening in the early 2000s, Flandro points out.

“Our research shows a similar, but smaller, disparity may exist today, as carriers continue to release large amounts of reserves,” he says. “Yet accident-year experience suggests that redundancies are fast diminishing.

Uncertainty spiral 

Historically, there’s been a strong relationship between reserve development and the underwriting cycle. So looking at the current reserving position of the market may hint at when the cycle may change.

Ed Hochberg, CEO, North America at JLT Re, believes that a deficiency in reserves could cause the market to harden in a fundamental way.

He says: “The longer-lasting impact occurs when reserves go upside-down. That creates uncertainty, because you don’t know where the bottom is. It makes senior managers and boards of directors nervous. It makes rating agencies nervous. And it makes companies feel uncomfortable about working with counterparties.

“That makes firms look at lines of business – and start withdrawing capital from them.”

Protective covers

Now is the time for cedents to consider buying protective covers, as these can become difficult to execute after the reserving cycle is perceived to have shifted unfavourably.

Protective covers can take many forms, including adverse development covers, loss portfolio transfers and reinsurance-to-close deals for Lloyd’s syndicates.

Freeing capital tied up in loss reserves can enhance capital management strategies and improve capital efficiency. And rating agencies typically look favourably on such protection, as it can enhance competitiveness, particularly in commercial lines. It can also support a firm’s valuation in negative reserving cycles.

“Cedents can secure a clear competitive advantage by anticipating cyclical changes and managing reserves accordingly,” says Flandro. “For those with the foresight to move quickly, cover is more available than it has been even in the recent past.”

Please contact David Flandro, Global Head of Analytics at JLT Re  on +44 (0)20 7466 1311 or email david.flandro@jltre.com