Why is the current pricing pain not yet impacting reinsurer ratings?

Since the disappointing pricing at the 1.1. renewal the bad news on reinsurance pricing has kept on coming. April, June and July renewals were all reported as materially down by the major brokers.

S&P adopted a ‘negative trend’ in its reinsurer ratings in direct response to the January outcome, Moody’s followed with a ‘negative outlook’ for the sector last month.  Best and Fitch by contrast maintain ‘stable’ outlooks but both are flagging the potential impact on sector ratings if the current environment persists.

However since the start of the year we have seen no reinsurer downgrades (using S&P’s ‘Top 23 Global Reinsurers’ as our peer group) or even negative changes to individual rating outlooks by any of the agencies.  Indeed, while most ratings assessed this year so far have simply been affirmed a few have even seen upgrades or positive outlook changes.

In no small part that’s explained by much of the cause of the pricing problem; excess capital, combined with a generally positive view from the agencies about the robustness of the sector’s risk management capabilities.

But all agencies routinely stress that their ratings are prospective and that forecast earnings quality (profitability and volatility) are central to that.

S&P’s detailed rating criteria highlights the point. Its capital adequacy model reflects a two-year forward view (currently the base case model is for 2016 in a reinsurer’s S&P rating), therefore critically including forecasted retained earnings. In addition its analysis of a rated reinsurer’s ‘operating performance’ reflects the current and subsequent year forecasts, ‘ERM’ focusses heavily on risk adjusted pricing controls and its ‘management & governance’ analysis hinges in no small part on a reinsurer’s ability to effectively set and deliver on financial targets. Added to this is the need for Cat exposed firms to ensure they do no stray outside of their ‘risk tolerance’.

Best’s too uses forward looking capital models and prospective earnings as a central part of the ratings process.

However, among S&P’s list of 23 all but 2 have already had their ratings at least affirmed by either S&P or Best’s since January. The 2 are Lloyd’s (currently a positive outlook from both agencies) and SCOR (currently a positive outlook from S&P and stable from Best). Individually S&P has yet to report on only 7 of the 23 so far this year, and Best on 10.

So, why is more rating pain not being felt?

The answer may come from how much actual earnings deterioration the agencies are so far forecasting. Again these days S&P is the most explicit about that.

Other than for the short-tail Cat specialists, in its recent rating updates the agency is typically forecasting ‘95% or better’ combined ratios this year and next.  Generally that’s only a few points worse than 2013 and similar to (and sometimes better than) 2012.  These forecasts assume a normal Cat year for any given reinsurer’s portfolio. (The Cat specialists of course generally operate with much lower combined ratios in a non-Cat heavy year).

Of course not all of the 23 are ‘pure play’ non-life reinsurers. Nonetheless this seems a tough circle to square with the headline pricing noise. Of course rate reductions can take a while to work through into quarterly or annual results but – given normal loss experience, and absent substantial further reserve releases – numbers reported by at least early 2015 should be expected to reflect the current pricing environment.

So either the headlines overstate the problem,  or key metrics such as loss and combined ratios, return on revenue and return on equity may start struggling to hit the ‘base case’ assumptions the agencies have in their current ratings.

Some reinsurers are more exposed to this than others in rating terms, particularly those where the current rating ‘bakes in’ a strong prospective operating performance and even more so if current capital is seen as marginal for the rating level but is supported by assumed positive future earnings.

So far the agencies have kept their powder dry.  As we’ve noted a before, it’s a tough call to take a negative rating action on a concern that future performance will worsen before seeing actual evidence that it has; but that, unavoidably, is what ‘prospectiveness’ in ratings requires.

The critical thing for reinsurers defending their rating in this context is to explain the defensive qualities of their competitive position (and the supporting ERM and other controls) to the agency in terms that reflect the agency’s criteria. When it comes to performance, credit rating analysts are ultimately interested in the ability to manage the down-cycle.

Rated companies do not always explain themselves to the agencies well. Some can rely too much on  unsupported assertions of strengths and their ‘persuasive powers’, while others may simply respond to the details of the agency questions without focussing enough on addressing the underlying issue (or even spotting it).

In this environment, to mitigate their future downgrade risk, reinsurers will need to focus clearly and coherently on how, and exactly why, they are able to manage the down-cycle.  A plea to the agency to ‘look at our capital and our track record’ may well not be enough.

Will ratings hinder reinsurer M&A and the hedge fund ‘play’?

In the investment banker ‘101’ playbook for cyclical industries the reinsurance industry has arrived at the page marked ‘weak pricing due to too much competition; sell M&A services to our clients’.

This, if you are a banker, can be a very nice place to be.  Less so of course for those clients that are the potential targets given that the ‘M’ in ‘M&A’ is rarely more than a fig leaf, but still there’s good money to be made advising the defenders.

Of course, an industry whose productive capacity is capital itself shouldn’t really be cyclical at all. There are no multi-year product development cycles, or billions locked up in factories, plant and machinery that have to be either ‘sweated’ or written-off.  A ‘rational’ reinsurance player can reduce volumes in a poorly priced market with an ease unheard of in most of business life.

Nonetheless cyclicality seems to prevail.

One could argue that since the current excess capacity is in part driven by the influx of ‘alternative capital’ what we are actually seeing is this driving a disruptive industry change to reduced pricing through a lower cost of capital rather than simply cyclical behaviour.

More generally, as Aon recently reported, there are ways for the traditional market to access that cheaper capital too.  If everybody’s capital gets cheaper then RoE targets should reduce (again meaning part of the pricing reductions could be structural not cyclical).

That said, few seem to actually believe that current pricing is sufficient.

So, for now at least, the mantra for many is ‘find more return’; either by consolidation, or pursuing more aggressive ‘hedge fund type’ investment strategies. Neither will be easily sold to the rating agencies.  Reinsurer M&A in a softening market has not always been a runaway success to put it mildly; the business case will not be easily made to the agency.

Increased market power can be a plus but it takes real scale in the reinsurance market for this to be much better than a neutral factor for a rating.

Cost efficiencies, if that’s the plan, are a positive of course but few reinsurer ratings are heavily influenced by this for the simple reason that – in a volatility based business – it’s management of that volatility (i.e. capital, underwriting and ERM) that drives the credit risk profile, not whether a reinsurer has rather overdone it in staffing up the marketing department.

Capital (rather than cost) efficiencies can work in the diversification sense; buying a well-established book is generally seen as less risky – reserve adequacy permitting – than organic diversification thanks to the avoidance of the anti-selection risk faced by new market entrants.

But if, one way or another, the plan involves a more aggressive use of the post-acquisition combined capital than that of the pre-acquisition acquirer, the conversation with the agency may not be straightforward.

Add to that the agencies’ inevitable concerns about execution risk and whether the acquired reserves are indeed adequate, and acquisitions at this point of the cycle (that are anything much more than ’bolt –ons’), can need some very persuasive logic to support the acquirer’s rating.

But what about ignoring the Banker’s siren calls and instead enhance returns via a hedge fund type investment strategy? Indeed this appears to being talked up as the industry trend ‘du jour’.

The logic is straightforward; while current reinsurance pricing limits healthy RoE’s the business still has the happy outcome of generating investable premiums up-front.  So, find a friendly hedge fund to spice up the investment strategy, focus on longer tail lines, and watch those enhanced returns roll-in.

Simple!

We are reminded of the 1980’s rhetoric of some Lloyd’s members’ agencies to prospective individual Names; “support your underwriting at Lloyd’s via a bank LOC based on your assets and  – shazaam – you magically get to use your capital twice!”.  The accompanying reality that, by doing so, the Name also had the privilege of risking their capital twice somehow seemed to get lost.

Not only was this ‘implied financial alchemy’ message successfully sold to non-experts, many industry participants fervently saw it that way themselves.

That seems bizarre with hindsight, but these things always do.

Yet a reinsurer actively pursuing a more aggressive investment strategy is doing exactly this; using and risking its capital twice.  And that is how the rating agencies will look at it.

More investment risk may or may not make sense in any given case but it is no generic solution to the problem of under-priced reinsurance.

To be fair, the expert asset management professionals involved will stress that it’s a lot, lot cleverer than that.  Asset/liability portfolio management can optimise the risk/return trade off and that’s the name of the game, but that’s a very hard trick to pull off in practice when a large part of that risk is derived from a soft reinsurance market.

Not that a case to the agency cannot be made, but demonstrating control of underwriting risk and pricing will, as ever, be crucial.  Writing for volume becomes a lot more enticing when the expected investment return goes up, and the agencies know that.

We recently read of one asset manager from a leading global firm who believes this trend will mean the agencies will have to adapt how they look at asset and liability risk when running their capital models on reinsurers.  Since the agency models have long factored investment exposures into their risk adjusted capital adequacy calculations we assume he means model changes would be needed to reflect the enhanced portfolio effect of ALM driven reinsurer investment strategies.

We suspect he will be disappointed. The last time the agencies allowed clever portfolio model analysis to mitigate the volatility of what were otherwise clearly high risk assets they ended up giving AAA ratings to pools of mortgages taken out by unemployed Americans.

And that, it seems reasonable to say, did not end well.

 

Stuart Shipperlee, Analytical Partner