A new special report, compiled by A.M. Best, concludes that the string of major catastrophes, a persistent soft market and the near exhaustion of excess reserves have placed global reinsurers at a “critical” point.

The rating firm said that the industry’s response to the situation may determine whether its outlook on the sector remains stable or turns negative. “Reinsurers face dual imperatives of surviving the soft market in the short term and positioning themselves for the eventual upward turn in pricing,” the report said.

Reinsurance markets, like financial markets everywhere, are distressed by uncertainty. Best’s report shows that at present there is no clear path indicating what the future will bring. While the recent catastrophic events in Japan and New Zealand are the current focus for reinsurers, Best points out that the accumulation of losses in 2010 –  from some 950 events, according to Munich Re – could potentially “turn the reinsurance market.”

The insured losses from those events were approximately $37 billion, which “dented the bottom line of most reinsurers but failed to squeeze out all the excess capacity that has existed in the market,” said Best. “Despite the catastrophe losses, underwriting profits continued in 2010, thanks to the ongoing flow of favorable loss reserve development from prior accident years and, more critically, the absence of a major U.S. hurricane.”

Increased debt at low interest rates and share repurchases highlighted reinsurers’ capital management activities in 2010. These initiatives had no effect on the continuing soft market; and Best said it remains concerned that the effects of recent catastrophes on pricing might be short-lived, yielding to a resumption of soft market conditions that would cause further destruction of capital and lead A.M. Best to place a negative outlook on the reinsurance sector.

Best’s report posits four different scenarios, and notes each one’s possible effects on the reinsurance industry, as follows:

  1. Optimism leads to disappointment. The property catastrophe market firms, but the result is only modest price increases, and the opportunity is short lived. The hope of a broad-based hard market remains distant.
  2. Costly catastrophe activity continues in 2011. A major hurricane that makes U.S. landfall, another major earthquake or some other exogenous shock depletes massive amounts of capital. In this outcome, a broad-based hard market across all lines of business appears certain.
  3. Japan’s government and insurers seek to place significantly more risk in the global reinsurance market. This scenario would necessitate a change in the current philosophy of the Japanese insurance market, which may not be such a remote possibility. Historically, a vast proportion of Japanese risk has remained with the Japanese government and the domestic Japanese insurance market. However, as the government and domestic Japanese insurers replenish their capital war chests, a paradigm shift may occur and they may seek a significantly greater amount of global reinsurance capacity to share more of the risk. As in a chess game where a player strategically positions pieces throughout the board, global reinsurance capacity is positioned and repositioned to exploit opportunity. A sizable reallocation of global capacity resulting from the Japanese quake could precipitate a broad-based hard market, as capacity would quickly become precious.
  4. The first quarter of 2011 is forgotten by year end, and the soft market lingers. This is the worst of all the scenarios, one that, Best said , may prompt it to revise its outlook on the reinsurance sector from stable to negative. A portion of the excess capital that existed at Dec. 31, 2010 has vanished. While A.M. Best expects companies to manage their remaining capital prudently, if the sector continues to underwrite at a loss and investment opportunities remain lackluster, it will lead to the further destruction of capital and necessitate a negative outlook for ratings.

Despite these challenges, Best described the global reinsurance market as having fared “fairly well.” The rating agency currently has a stable outlook for the global reinsurance market, which, it said, “implies that the majority of 2011 reinsurance rating actions are likely to be affirmations, with only a modest number of changes anticipated in ratings or outlooks.”

Best also indicated that it considers the catastrophes that have occurred over the past 15 months to be “manageable from a capital perspective.” When Best assigned an overall stable outlook at the beginning of 2011, “global reinsurance companies were strongly capitalized and adhering to underwriting discipline.” As a result Best described the “shocks thus far” as “earnings events, not capital events.” But it also cautioned that “while balance sheets remain solid, these multiple events are adding up.”

Best concludes that the “market seems to be at an inflection point.” Of the four different scenarios, Best reiterated that it is concerned that the first – a short-lived pricing boost in property catastrophe lines of business – will flow into the last scenario: “short memories perpetuating the soft market,” resulting in a considerably smaller capital cushion entering 2012. “This seems distinctly possible, barring significant catastrophes for the remainder of 2011 and/or a paradigm shift in the Japanese insurance market,” the report said.

If the worst-case scenario unfolds, Best indicated that it would consider revising the ratings outlook to negative, as pressure on ratings would be expected to increase.

Source: A.M. Best