For most insurers and reinsurers, an AM Best rating is a requirement of doing business. The rating agency uses quantitative and qualitative models to evaluate both the market as a whole and individual firms. These models are about to undergo their most significant upgrade in over 20 years.
In the first part of this interview, Robert DeRose and Greg Reisner set out AM Best's perspective on the state of the market, the risks that could lead to downgrades and where new capital is likely to flow after a large event.
In part two, Jim Gillard and Tom Mount explain why AM Best is updating its rating model and the likely impact on the market. Users who have registered (for free) can read part II here.
What is driving the higher trading multiples amongst reinsurers?
GR: Trading multiples aren't the highest they've ever been, but they're certainly higher than they were three to five years ago. The main reason really is that the rising tide lifts all boats. If I'm not mistaken the S&P 500, is not far off all-time highs. So it's just the fact that the broader market is up and reinsurance valuations have been moving up with it.
BDR: It's certainly not supported by the fundamentals of the market. Market fundamentals are weak and quite frankly they continue to weaken. Earnings prospects for reinsurers are not bright, so it's not really driven by the earnings momentum.
What are the current underlying RoEs for the reinsurance industry?
GR: If we strip out favourable loss reserve development and if we assume there was a normal cat year, which we really haven't had for a long time, we're thinking RoEs are actually in the low single digits, which is a concerning prospect.
When will we see the end of reserve releases?
BDR: That's a question nobody really knows the answer to and it differs from company to company. We have started to see some signs of adverse development in specific classes of business, and overall on a percentage point basis, the amount of reserve releases has come down.
For some reinsurers, and I'll cite Munich Re as an example, they had significant reserve releases in 2015 - outsized in comparison to their historical annual average. But for the majority, the reserve development on a point basis is declining. Certainly the ability to take redundancy out of the hard market years has dwindled significantly and the fact that there really haven't been any significant catastrophes isn't really enabling companies to put away additional reserves that would fund subsequent losses.
And then we look at the pricing dynamics of the current accident years, and if companies aren't cheating so to speak, there are insufficient reserves up for those accident years, which will lead to reserve strengthening going forward. So a combination of all those factors will ultimately diminish the current level of favourable development and may actually at some point transition into more pockets of adverse development.
What features of the soft market are you most concerned about?
BDR: Pricing is soft across a broad category of classes. Property catastrophe in the US is the one everyone talks about the most because it has experienced the greatest level of decline. For all of them - marine, energy and aviation, professional and general liability - the competitive landscape is quite challenging and rates across the board are flat to down.
And there has been a broadening of terms and conditions - certainly in the catastrophe classes of business. To quote Warren Buffet: you really don't know who is swimming naked until the tide goes out. We have a dialogue with companies and they tell us they are being disciplined, but we have been surprised in the past where companies have professed to be disciplined and losses have been outside of our expectations and the company's expectations.
Benign catastrophe years result in a continuation of a build-up of capacity and that makes the market conditions just a little bit more challenging. It's the pricing and the terms and conditions. We are seeing capital management strategies out there - there are some increased dividend payments - and also I do think some companies are building up cash resources to potentially do M&A.
The good news at the mid-year renewals was that the rate of decline is slowing, but it's still a rate of decline. Companies say there are pockets of opportunity, so it's all about selecting the right risk and making sure that diversification in your portfolio is balanced so that if there is an event, you don't get an outsized loss.
GR: The other source of returns for re/insurance companies is investment income and yields are just abysmal - even negative in some European countries. And when you put that into the equation, the net balance has definitely eroded. Benign cat years have certainly attracted more third-party capital because they're looking at the last few years of earnings and they're seeing things have been relatively benign.
On the flip side we're seeing the PMLs of traditional companies trending downward, so it does suggest there's a certain level of discipline and they certainly haven't let their guard down from year-to-year, especially any company or management team that's been in the business for a long time.
What kinds of exogenous developments (reinsurance market or global economic) could lead to AM Best downgrading reinsurers?
GR: Right now we don't expect RoEs on a reported basis to be much better than eight to ten percent. Some companies are doing better but they're probably taking on more risk to achieve that. So when there is a major event, and one will occur, if the loss is outside of our expectations, that would lead us to believe the enterprise risk management was not performing as expected. That would potentially lead to a negative rating outlook or even a rating downgrade, depending on the size of the loss relative to expectation.
Which types of reinsures are most likely to attract capital after a market-changing event?
BDR: Post event, I'm not convinced that capital is going to flow to the rated balance sheet the way that it has historically. I don't think you're going to see the same amount of start-ups or the equity raises post event. Maybe that's one reason why rated balance sheets are sort of hoarding capital now because they probably recognise that it won't be as free flowing as it had been historically.
But I do think those entities that have a good track record in terms of performance and that can attract third-party capital to a temporary or third-party vehicle can take advantage of the market dislocation that occurs post event.
GR: A lot of companies are building up a track record of managing third-party capital in addition to their own capital and I think that is also helpful.
Users who have registered (for free) can read about AM Best's new methodology here.
Posted: Monday, August 1st, 2016