Catastrophic weather shakes up the reinsurance market
Recent major weather events in Australia, Mexico, the Caribbean and the United States, including three hurricanes that were Category 4 or greater, have resulted in catastrophe losses exceeding $100 billion for the third year on record.
But the large insured loss, currently estimated at a record $111 billion before accounting for National Flood Insurance Program losses and the California wildfires, has created a perfect opportunity for the reinsurance market to showcase its ability to adapt solutions to the unique risk profiles of individual clients.
The value of reinsurance as a capital substitute was apparent during the 2008 financial crisis, when debt and equity financing was difficult to obtain. In its place, the reinsurance market demonstrated its ability to protect balance sheets, manage earnings and reduce volatility. Now, the series of catastrophic events in 2017 — earthquakes in Mexico and hurricanes Harvey, Irma and Maria — is reminding corporations, primary insurers and reinsurers that (re)insurance is one of the most effective ways to protect corporate capital bases from these events.
The third quarter of 2017 is likely to be one of the costliest in the insurance industry’s history. While it is still early and loss estimates likely will fluctuate, total catastrophe losses of just $75 billion would mean a combined ratio of 106 percent for the world’s top 20 reinsurers, according to A.M. Best. Although there appears to be little risk to solvency, earnings of individual insurers will be affected, and in some cases, excess capital positions and catastrophe budgets may be eroded, which could result in ratings actions.
Record capital levels
Fortunately, the U.S. property and casualty industry is sitting on record capital levels and the global reinsurance market adds $427 billion, so the sector is well-positioned to absorb such losses. But despite years of low reinsurance rates and low interest rates that have reduced the industry’s profitability since the last material rate increase after Hurricane Katrina, we do not expect a similar price revision this time around. Reinsurers have built up cash during the recent favorable years, while capital-market investors seeking non-correlated investments, such as hedge funds and pension funds, have put record amounts of money into catastrophe coverages.
Harvey on its own probably will not require an increase of industry capital; the addition of the cumulative effect of the earthquake in Mexico and hurricanes Irma and Maria, however, could create a capital event. Yet with abundant capacity — and, of course, depending on the final numbers — the aggregate impact may be a one-time firming of rates within specified regions or coverages or a halting of decreases that recently began to moderate as reinsurers’ margins approached breakeven. We also expect casualty reinsurance rates to continue their recent trend of declining year-over-year rate reductions.
Rise of insurance-linked securities
Insurance-linked securities (ILS), which provide about $82 billion of the reinsurance industry’s capital base, likely will continue to generate demand and augment traditional reinsurer capacity. Although the recent events may provide the first real test of alternative capital, investors have indicated they are prepared to recapitalize or increase their current positions, and in some cases they already have.
Earthquakes and hurricanes provide an opportunity to define the viability and effectiveness of catastrophe bonds, creating either a day of reckoning or a day of glory for the ILS market.
Thus far, we have seen these catastrophe bonds demonstrate their effectiveness and serve their intended purpose. Of course, the eagerness of investors to return to the market may be tempered by a possible capital lockup. Until all claims are settled, investors’ assets collateralizing the transaction cannot be released, which could cause them to offset any new ILS capacity offered against these withheld funds.
The ability to trade certain classes of cat bonds in the secondary market enhances their liquidity if funds are withheld. Insurance company sponsors are monitoring payout patterns compared to the traditional market. Any payment disputes from ILS investors could provide reinsurers an opportunity to demonstrate their value-add to clients.
Assuming the ILS market responds to these catastrophes as defined, this capacity likely will remain an integral part of insurers’ capital structure, even when interest rates rise. Most ILS issuances define interest rates as a risk spread on top of return on U.S. Treasuries or to LIBOR, so the asset class will remain attractive as interest rates rise. ILS is now very much ingrained in the overall risk community, creating a pool of diverse capacity collectively serving and supporting the (re)insurance industry.
Overall, we expect the reinsurance marketplace to remain vibrant and continue offering a full range of products, supporting growth in reinsurance purchasing in virtually all its forms. Industry capital is at an all-time high, and clients are expanding covers, fully leveraging a broader array of solutions as the industry modernizes in the face of technological innovation. In addition to transactional products, reinsurers and ILS providers are developing more comprehensive, consultative value propositions, such as capital advisory and enterprise risk management services.
These offerings withstand market cycles and macroeconomic factors and provide insurance companies with a dedicated, informed partner to support new product development and growth initiatives. This creates opportunity by leveraging advanced platforms and innovative customized solutions, such as coverage features applying to specific industries or risks unique to specific clients.
Advanced modeling techniques
As economic growth and demographic patterns impact risk concentrations, advanced modeling techniques will help ensure sufficient vertical and horizontal reinsurance coverage to support post-event liquidity and close the protection gap, especially around historically difficult risks such as floods. Only 27 percent of those affected by Hurricane Harvey had flood insurance, and sustained industry profitability will depend on increasing global insurance penetration.
Complex emerging exposures such as cyber and terror also are increasingly finding solutions in the reinsurance market, and optimal structuring of coverage can minimize regulatory capital. By tapping a variety of capital sources, structures and modeling capabilities, insurers are matching more efficient, customized solutions to their unique risk profiles, whether they are focused on protecting earnings against attritional losses or shielding their capital base from catastrophe losses.
As the industry enters the 2018 renewal, the market remains strong with a variety of solutions to deliver the right capital to risks. Following the recent catastrophes, reinsurers are adjusting business plans for opportunities in marine, energy, flood and specialty lines of business. In today’s world of unprecedented disruption, the (re)insurance solution for managing capital and earnings is as relevant as its solution for severity protection.