While pressure on risk-adjusted capital adequacy has reportedly been the prime source of lower reinsurer ratings, a crucial additional component has been the posting of only modest underwriting profits in property/casualty to date in 2003. Expectations for the full year are not much better, commented A.M. Best Co.
In a low interest rate environment, underwriting returns are the fundamental source of reinsurers profitability. This in turn translates into likely future capital adequacy as ultimately the availability of capital to reinsurers is a function of their ability to produce a sufficient risk-adjusted return.
With the pricing environment as attractive as it has been for several years, combined ratio’s for many reinsurers in the mid 90’s or higher for the first half of 2003 were reportedly disappointing, especially with few reinsurers recognizing any adverse development coupled with benign catastrophe experience during the period.
According to A.M. Best, some reinsurers stress that this reflects the ‘lag’ of rate increases showing through in booked results. While clearly there is some truth in that, the degree of result improvement appears to be slowing, suggesting this issue may have largely played out. With property rates peaking globally, and casualty becoming more competitive – as well as continuing loss cost inflation – the potential for real further rate increases is small. Accordingly, unless the market’s traditional cyclicality has been eradicated, it is difficult to see how healthy returns will be maintained when the market turns.
There are reportedly some exceptions. The Bermuda market in particular has generally outperformed the rest of the industry, although a comparison of earnings quality needs to be considered in the context of the potentially more volatile earnings of some of the Bermuda based companies.
The pressure on reinsurers not to cut rates remains severe. Reduced risk-adjusted capital and the ongoing potential for adverse development themselves are major sources of price discipline. But purely rationale pricing behavior is not a feature of any market and reinsurance is no exception. Signs of price-based competition are clearly emerging.
Accordingly, A.M. Best believes it is unlikely that underwriting returns sufficient to support the capital necessary for the very highest ratings will be a feature of the next few years for most market participants.
Consequently, while there may be some individual exceptions due to specific capital raising initiatives, financial strength ratings overall are unlikely to return to former levels. Moreover, the management for many reinsurers is increasingly stressing the need for maximizing the risk-adjusted return on capital employed. In that context, very high levels of risk-adjusted capital may not seem to be economically tenable to some reinsurers, and, as a consequence, they may choose to live with lower ratings.
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