Given the abundance of capital in the reinsurance sector, market conditions are likely to remain relatively stable in the short term. Although capacity levels may be affected at the margin by continued mergers and acquisitions (M&A) activity and/or carrier withdrawals from some under performing classes of business, there is more than enough capital on the sidelines to offset any conceivable reduction.
But this is not to say market conditions will remain the same forever. As alluded to previously, market cycles are typically not the product of isolated events but the result of an accumulation of factors, both within and outside the sector, that have coalesced over several years. The underlying drivers behind the recent soft market, for example, were linked to a confluence of macroeconomic forces following the financial crisis, combined with traditional and non-traditional market dynamics.
Given that today’s global macroeconomic environment may be on the cusp of another material shift, this is a particularly pertinent point. Indeed, nascent trends could potentially signal the end (or moderation) of ‘new normal’, post-financial crisis conditions and precipitate meaningful market change in the near to medium term. A combination of stronger GDP growth, higher yields and rising inflation suggest that the coming year could be one of economic transition, with important implications for carriers’ growth and profitability.
1. RISING INTEREST RATES
As the largest class of investors in high-grade fixed income securities, (re)insurers are particularly exposed to sharp movements in interest rates. The ‘flight to quality’ that followed the financial crisis meant carriers’ investment returns fell to unprecedented levels as interest rates were cut to post-war lows across much of the developed world. However, the improving economic outlook over the last couple of years has seen some central banks tighten monetary policy and government yields recover, albeit from low bases (see Figure 13). The accompanying increase in corporate bond spreads (as shown by Figure 14) is likely to translate into higher investment returns for most carriers compared to the recent past.
Figure 13: 10-Year Yields for Government Bonds – 2016 to 2018 (Source: JLT Re, Bloomberg)
Figure 14: 10-Year Spreads for BBB/Baa-Rated Securities – 2017 to 2018 (Source: JLT Re, Bloomberg)
2. SHIFTING YIELD CURVE
It is also important to note that with yields still near all-time lows but shifting higher, fixed-income securities can become more sensitive to sudden changes in interest rate expectations. Under such circumstances, asset values are more susceptible to unexpected declines, stressing balance sheets and potentially creating short-term liquidity problems for certain companies. These risks should not be underestimated, given the yield curve shift that has begun to occur (see Figure 15).
Figure 15: Changes to US Investment Yield Curves – 2015 Versus 2018 (Source: JLT Re, Bloomberg)
The move from a steeper and lower curve to one that is today higher and flatter can be indicative of increased investor concern about near-term economic deterioration, which, should it come to pass, would obviously adversely impact (re)insurers’ balance sheets, as it did during the last recession. Whilst concern about the economic outlook may seem surprising to some, especially given the recent performance of the US economy, it should be remembered that 2018 represents the ninth year of economic expansion for most western countries.
The shifting yield curve could also have knock-on impacts on pricing. Rates for short-tail business may come under additional, albeit marginal, pressure as some carriers benefit from higher yields on short- and medium-duration securities, which dominate (re)insurers’ portfolios. Conversely, pricing for longtail business may need to increase to compensate for the reduced relative returns carriers will receive on longer duration investments.
3. INFLATION AND RESERVING
Rising inflation is also likely to exacerbate pricing pressures for long-tail business. Figure 16 shows how consumer price indices have broadly risen in the US, UK, Germany and China in the last two years. This is causing claims costs to build as wages rise, medical and litigation costs increase and protectionist measures add to the inflationary environment. These developments are certain to have important implications for reserving and profitability.
After all, the benign inflationary environment following the financial crisis helped carriers release large amounts of redundant reserves into earnings, thereby compensating for low investment yields as well as elevated catastrophe losses in certain years. Now that carriers are likely to have released most of these reserves, and inflationary pressures are rising, the reserving cycle is firmly under the microscope amidst concerns that it has reached an inflection point.
Figure 16: Consumer Price Indices – 2016 to 2018 (Source: JLT Re, Bloomberg)
Reserve adequacy is notoriously difficult to predict but JLT Re in 2016 conducted an exhaustive analysis of reserving trends. This research has been updated to show reported calendar year reserve movements by quarter for the top 30 global (re)insurance companies up to the first quarter of 2018 (see Figure 17). For comparison purposes, Figure 17 also includes accident year loss development for all lines of business (shown by the orange line).
The analysis implies that the sector remains in a danger phase in which carriers are continuing to release reserves even as accident year experience indicates that redundancies are diminishing. After net reserve strengthening was recorded in the fourth quarter of 2016, P&C carriers continued to release reserves through to the first quarter of 2018. It is nevertheless important to note that releases ran particularly thin in the third and fourth quarters of last year, implying that carriers may no longer be able to rely on reserves to protect or enhance profits as they have done since the mid-2000s. Indeed, the overriding trend in recent years towards fewer reserve releases is clear to see. Building inflationary pressures are only going to compound and accelerate this development.
Figure 17: Calendar Year Reserve Development by Quarter for Top 30 Global P&C Carriers Versus Accident Year Reserve Experience – 1998 to Q1 2018 (Source: JLT Re)
2018 has been a clarifying year for the reinsurance sector. Despite the market suffering one of its most expensive catastrophe loss years on record in 2017, reinsurance buyers continue to have access to competitively priced capacity. In stark contrast to the dislocations that have frequently followed large losses in the past, the market in 2018 has been characterised by its resilience, as capacity has remained stable or even increased. This is a market which has matured materially since the days when large catastrophes created massive price volatility.
Fierce competition in the property space has been one of the year’s dominant themes as capital inflows have continued unabated, with alternative capital providers replenishing and increasing investments. This, along with benign loss activity so far in 2018 and comparatively limited claims development for HIM, has caused property pricing increases to fade as the year has progressed, particularly in areas where ILS markets are most active. Conditions beyond the property market also remain broadly positive for cedents, although pockets of rate firming have emerged for certain casualty lines as reinsurers in these areas are realigning risk appetites now that they can no longer rely on high-margin property returns to subsidise pricing in these areas.
Given the abundance of capital, market conditions look set to favour buyers heading into 2019 renewals. Whilst loss activity between now and then will, of course, be crucial, the reinsurance market is strongly positioned to deal with most potential loss scenarios. As this report has shown, any future market turn is likely to come about only if capital withdraws, and no such development is likely in the short term. But circumstances can change quickly and external forces, such as changing macroeconomic trends, need careful consideration as they are still capable of creating reserve volatility and further stressing carriers’ balance sheets.
By deploying reinsurance strategically, cedents can navigate successfully today’s operating environment and pursue more profitable business. JLT Re is committed to delivering best-in-class advice and risk transfer products to support clients in this endeavour. By investing in analytics and research, and drawing on the vast array of expertise within the firm, JLT Re is uniquely placed to inform the discussion around evolving market dynamics and thereby create the most effective and innovative solutions for our clients.