09 September 2013

Fitch: Returns, not alternative capital, main risk to reinsurers

Weak investment performance will hurt earnings across the sector in 2014, whereas competition from new capital is likely to remain focussed on the property catastrophe market, although the impact will probably contribute to weaker pricing in other classes.

Fitch expects investment yields to remain relatively low through 2014, making it difficult for reinsurers to supplement underwriting profits with investment income. A falling profit contribution from prior-year reserve surpluses will also contribute to weaker results in 2014, though Fitch expects most reinsurers to remain profitable. The eventual return of higher yields would be positive for the sector's credit profile, but the transition may not be smooth as rising interest rates have a negative short-term impact on balance sheets.

Fitch believes alternative sources of capital, such as catastrophe bonds, quota-share reinsurance vehicles and hedge fund-supported reinsurers, are here to stay. However, their impact will lead to an evolution of the market rather than sweeping reform.

So far capital market alternatives to traditional reinsurance have been largely restricted to the market sectors that are perceived to have more accurately modelled risks, such as catastrophe-exposed US wind reinsurance. Due to the requirements of investors in alternative reinsurance, Fitch expects this focus on well-modelled risks to continue, with a growth of alternative capacity for perils including European wind.

Meaningful expansion of alternative capital into other perils and non-peak zones of catastrophe reinsurance, such as flood, will be slower, due to the more limited availability of accurate models and loss data. The development of the casualty reinsurance market will be far harder because some alternative reinsurance structures are not currently capable of dealing with long tail risks. Innovative structures that cut off the tail of casualty losses, providing alternative capital providers with finality, would help.

Over time, traditional reinsurers are likely to respond to the growth of capacity provided by alternative capital by targeting expansion into emerging markets and non-catastrophe exposed lines of business. But they will also see some benefit from the development of the alternative market, including further options for managing exposure and additional fee income through the provision of underwriting and other technical expertise.

While alternative capital will only be a significant source of reinsurance in a few markets, it is likely to have a wider impact on pricing due to the overall increase in surplus underwriting capacity. Fitch expects to see weaker pricing across most markets and classes of business when contracts are renewed in January. But pricing is likely to remain adequate and traditional reinsurers will not seek to significantly increase volumes.

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