The reinsurance sector's return on capital is expected to increase to around 6%-8% by year-end 2018, says S&P Global Ratings. However, this remains close to reinsurers' cost of capital, which S&P anticipates will increase modestly through the rest of 2018 and in 2019, remaining within the 7%-8% range.
In 2017, the reinsurance sector generated returns on capital of only 1.2%. At 6.3% below its cost of capital, this represents the worst level in more than 13 years. The impact of the 2017 U.S. hurricane season was a significant factor, but even during the benign first half of 2017, returns were only 1 percentage point higher than the cost of capital.
Despite the optimism reinsurers showed when heading into the 1/1 2018 renewal season, overall reinsurance renewal rates have only modestly increased and the momentum is weakening, as witnessed through the latest renewals. While reinsurers welcome rate increases, their profitability continues to be hampered by persistent competitive pressures within the property/casualty underwriting cycle and low investment returns, which will initially lag the increase in benchmark rates as reinsurers' investment portfolios have an average duration of around 3.4 years.
S&P is also seeing signs that prior-year reserve releases could decline, which will add to the earnings pressure. Some reinsurers have already demonstrated this during 2016 and 2017, following the UK's Ogden discount rate reform, and, in some cases, individual reserve strengthening has even taken place in selected lines like US casualty and Australian disability.
Except for 2011 and 2017, there have been relatively few major catastrophes since 2005 which have helped reinsurers realise returns that have exceeded their cost of capital. For 2018, S&P assumes modest price increases of 0%-5% across the board, with property catastrophe reinsurance pricing still an estimated 30% below 2013 levels.
As of 31 December 2017, the cost of capital for S&P's peer group of global reinsurers had declined by around 250 basis points since 2005, to about 7.5%, including an increase of around 90 basis points during 2017. This overall decline since 2005 is due to a combination of:
- A reduction in the cost of equity, caused by the reduction in risk-free rates, combined with the declining return from competing asset classes such as bank equity investments.
- A reduction in the cost of debt, again caused by lower risk-free rates, combined with overall improvements in the sector's capitalisation, and thus creditworthiness.
- A modest increase in the proportion of debt funding on reinsurers' balance sheets today versus (more expensive) equity funding.
- An increase in supply of capital into the reinsurance market as hedge fund investors, pension funds, sovereign wealth funds, and high-net-worth investors look to diversify their portfolios by adding catastrophe risk. These investors have a competitive advantage over traditional reinsurers in that their cost of capital (long-term return) targets tend to be lower than reinsurers' weighted-average cost of capital (WACC), allowing them to profitably assume risks at prices that would be uneconomical for the traditional players.
Investors are likely to stick with reinsurance
Nevertheless, S&P's base-case assumption is that most reinsurance equity investors will reluctantly accept lower returns on their reinsurance holdings, rather than exit the sector. Given prevailing low (albeit rising) interest rates, investors remain hungry for yield.
Should investors withdraw their capital, one consequence would be that reinsurance rates could increase as the excess capital in the reinsurance sector reduces.
On a more normalised basis, the 6%-8% forecast return on capital in 2018-2019 still compares relatively favourably with other industries. Investors have limited options elsewhere that offer more favourable or even comparable returns.