CAT EXPOSURE
Global Reinsurers’ Appetite For Catastrophe Risk Remains Largely In Check
By Charles-Marie Delpuech and Jason S Porter
Extremely strong capital adequacy is providing some resilience to the cat sector, which continues to show disciplined risk management, although some relaxation in terms and conditions is adding to capital and earnings volatility.
Profit margins in the natural catastrophe segment of the reinsurance industry are set to shrink in coming years, which could negatively affect several rating factors. For example, capital and earnings volatility may increase, weakening our assessment of risk position, while lower profits may drive down our assessment of industry risk and competitive position (see “Insurers: Rating Methodology” published May 7, 2013, on RatingsDirect). Here, we present our findings from the analysis of several benchmarks we have created to help assess the risk position of the reinsurers we rate. These benchmarks compare: • Earnings-at-risk and capital-at-risk exposure,
• Post-event capital adequacy, • Profitability impact, • Business mix, • Geographical diversification, and • Historical claims experience.
We believe that the range of exposure to catastrophe risk is captured in our assessments of risk position (see “Tough Competition Could Put Ratings On Global Reinsurers Under Pressure”). Our analysis of these benchmarks generally finds that extremely strong capital adequacy is providing some resilience to the industry, which continues to show disciplined risk management. Exposure to unpredictable and high- severity natural catastrophe events adds to reinsurers’ earnings and capital volatility. Our average “high risk” assessment of the reinsurance sector’s risk position captures the
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volatility arising from this exposure. Indeed, we find that the catastrophe risk contribution to a reinsurer’s capital volatility is relatively high as measured by earnings-at-risk exposure to a one-in-10 year annual aggregate net loss and by capital-at-risk exposure to a one- in-250 annual aggregate net loss (see Chart 1). We have observed only a slight shift in catastrophe exposure in response to the price decline, despite a modest uptick in exposure to more frequent (one-in-20-year) catastrophe loss years. The capital-at-risk exposure (measured as the impact of a one-in-250- year annual loss to the sector’s shareholders’ equity) remains largely aligned with what we have observed in the past couple of years at an average of 36%, nevertheless it is slightly lower than in previous years because capital positions strengthened during 2013. We believe that reinsurers are better protected against high-severity losses than in previous years through retrocession (the reinsurance of reinsurers) with the most pronounced impact on reinsurers’ exposures for one-in-100, or larger, loss years. In addition, many reinsurers have reported purchasing additional retrocession during 2014, which would not appear in our data collected up to Jan. 1, 2014. Bermuda-based short-tail reinsurers (those that specialize in relatively low- frequency and high-severity events) and London-based reinsurers exhibit higher- than-average appetites for catastrophe risk. On the other side of the spectrum are the large global reinsurers, which are inherently
more diversified. Despite the range in the risk appetites that we observe among reinsurers, we believe they are continuing to manage their catastrophe risk preferences within well- defined risk limits.
Earnings Volatility Could Increase, Reducing Loss Absorption Capacity
Based on our analysis of 2012–2013 earnings, a one-in-10-year loss (for the reinsurers we rate) would deplete on average about 75% of annual reinsurer profits (see Chart 1). However, the decline in catastrophe rates may drive this ratio higher as annual profits shrink. In addition, because reinsurers have slightly increased their exposure to more frequent types of natural catastrophes, smaller events could have a greater impact on earnings in the future. In turn, the probability of negative underwriting returns on catastrophe lines increases. Furthermore, we may be underestimating the size of the loss if recent history is any indicator; should the worst loss of the past 10 years occur again, the sector would lose on average 112% of annual profit.
Retrocession and alternative capital are helping reinsurers cope
Although catastrophe rates have been trending down, retrocession rates (on reinsurance purchased by reinsurers) have been decreasing even faster partly due to capacity from alternative capital vehicles (third parties that provide capital through risk transfer arrangements such as catastrophe bonds).
Global Reinsurance Highlights 2014
SHUTTERSTOCK / PIO3
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