This gives reinsurers an opportunity to hedge their exposures and lower their own cost of capital. An excessive reliance on retrocession could nevertheless leave reinsurers dependent on a potentially unreliable form of capital and create counterparty concentrations, if not appropriately managed (see “Natural Catastrophes Are Unlikely To Trigger Systemic Failures In Insurance”).
The relaxation in terms and conditions is adding to capital and earnings volatility Reports of relaxed terms and conditions in the catastrophe risk sector, including extended hours clauses, the inclusion of terrorism exposures, multiyear contracts, and cheaper reinstatement premiums, increase risk exposure and aggregations, and are a signal of a degradation of underwriting discipline. Although seemingly contained for now, such features are a leading indicator of a soft market that may add to earnings and capital volatility.
Excess Capital Is Acting As A Cushion Our stress tests of different severities of potential catastrophe losses, which we conduct annually for each reinsurer we rate, show that a one-in-250-year annual loss year could reduce the capital adequacy of the reinsurance industry to a level commensurate with a rating in the ‘A’ category from an extremely strong position, which is a reasonable outcome for such an extreme scenario (see Chart 2). In that case, the capital adequacy for about two-thirds of reinsurers would remain above ‘BBB’. Reinsurers that are most exposed to these extreme scenarios are some multiline Bermudians with lower levels of capital relative to their peers’ and some London players that have a lower starting point for capital adequacy and a higher appetite for catastrophe risk. Should an extreme loss occur, those companies with the weakest post-event capital positions could struggle the most to recapitalize, particularly given the potential that alternative capital could be a more attractive avenue for new capital and could mute any subsequent spikes in catastrophe pricing.
The Least Diversified Businesses Will Face The Most Challenges
Pressures from falling catastrophe rates fall most squarely on the shoulders of reinsurers concentrated in property catastrophe risk; players with a more diversified business mix are less exposed. We assess that, on average, one-fifth of reinsurer revenues are exposed to property catastrophe risk (see Chart 3). As rates further decline, we see that many
Global Reinsurance Highlights 2014
Chart 1: Earnings At Risk Versus Capital At Risk Positions
0.0 0.2 0.4 0.6 0.8 1.0 1.2
Midsize global Bermuda
Global
Property catastrophe/Short-tail London
010
20
30
PBT = Profit before tax. Data as at Jan. 1 2014 © Standard & Poor's 2014.
40
50
60 1-in-250-year net catastrophe loss versus shareholders' equity (%)
70
80
Chart 2: Risk Appetite And Catastrophe Loss Impact On S&P's Total Adjusted Capital At Different Return Periods
'BBB'
20 40 60 80 100 120 140
0 'AA' 'A' 'AAA' Net 50-year loss impact
Net 250-year loss impact Net 10-year loss impact
Net 100-year loss impact Total adjusted capital
Data as of Jan. 1, 2014. © Standard & Poor's 2014.
reinsurers are, not surprisingly, slightly rebalancing their business mix toward classes not exposed to catastrophe risk. However, any significant change in business mix will prove challenging, especially for smaller players, because prices are also trending downward in other traditional reinsurance classes. The effect on profitability of a large catastrophe event would be substantial. We estimate that a one-in-250-year loss year would add, on average, 57 percentage points to the loss ratio based on reinsurers’ current business mix, or 42 points excluding the short- tail specialists (see Chart 3). Annual losses recorded in 2011, which were the worst in the past five years, added 29 percentage points to the combined ratio. The property catastrophe short-tail reinsurers appear to take more catastrophe tail risk (for low probability
events at the return period above one-in-250 year) relative to their catastrophe-related revenue. Bermudian and global players appear relatively less exposed.
We find that the impact of catastrophe losses on underwriting results is less volatile for global players because of their more balanced profiles. London reinsurers, on average, recorded the lowest catastrophe losses (see Chart 4). For the reinsurers under study, we compared the five-year average contribution of annual catastrophe losses with reported combined ratios (the industry’s main profitability ratio comparing revenue from premiums to losses and expenses) and the relative volatility in the contribution. We find an average 12 percentage point contribution to the combined ratio for the industry based on the past five years of annual catastrophe losses.
59
As a percentage of total adjusted capital (%) Aggregate
1-in-10-year net catastrophe loss versus PBT (2-year average) excluding catastrophe loss (x)
North America Europe
catastrophe/ Short-tail
London Bermuda
Midsize global reinsurers
Global Property
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