Will the insurance cycle ride to the rescue?

Adam Szakmary, Director of Underwriting, Hiscox Re argues the losses of 2017 and 2018, together with the impact of wider macro-economic factors, are bringing a cautious re-evaluation of reinsurance pricing which could see a much-needed upward trend in prices.

Following the insurance market’s worst-ever two-year period for losses and on-going uncertainty in global financial markets, what will it take for the insurance cycle of days gone by to rebound?

Overall reinsurance pricing largely stayed flattish in January, with those areas unaffected by recent catastrophe losses seeing continued pressure while loss-affected accounts saw moderate pricing improvement. Market rates remain well below historic peaks; in the US, pricing continues to languish at close to half of 2006 levels and the story is not much better in the Asia Pacific region, where prices are still one-third lower than 2012 levels.

Will rates continue to fall as trapped capital is released moving in to 2019, or will investors and underwriters alike come to their senses and collectively agree that the market for catastrophe risk needs to fundamentally change?

Losses mount

There is no sugar coating the last two years when it comes to losses. The combined catastrophe and man-made insurance losses of 2018/2017 are estimated to reach USD$230 billion, outstripping the previous peaks of 2004/2005 and 2011/2012. Equally important, although less apparent from the quantum described above, is the degree of uncertainty the market continues to experience around reserving, risk severity, and loss development from less well-understood perils. The question that underwriters are now asking themselves centre around the adequacy of rate by region at this point in the cycle, and the willingness of cedants, many who are heavily reliant on their large reinsurance programmes, to recognise the something has got to give.

2018 losses were felt more heavily by the reinsurance market than in 2017, which may have come as an unpleasant shock to some ILS investors given total insured losses were much smaller than the previous year. Perhaps in part because of these nature of these losses, ILS investors decided not to reload their capital allocations as much as was forecast; although less available capital has not immediately translated to pricing improvement.

Investment returns dwindle

Unfortunately, if the market thought returns from their other investments would soften the impact of all these losses, then the volatile performance of the financial markets over the last year offered cold comfort. Over the last 30 years – roughly the age of the modern catastrophe reinsurance market – there have been only two years where all four major investment asset classes delivered negative year-on-year returns, and 2018 was one of them. Not only has this impacted reinsurers earnings for 2018, it also leads to a contraction of overall assets available to back reinsurance underwriting, which constrains reinsurers’ ability to write more business in future years.

Underwriting uncertainty

What does all this mean from an underwriting perspective? There are some obvious factors that should be considered by underwriters: are the contracts being written now optimally structured? Are the perils contributing to the losses understood well enough? Even in peak zones like Florida and Japan, is there still the same comfort in the models for short tail perils, given how much 2017 and 2018 losses have continued to erode? The growing lack of certainty in loss expectations means volatility margins must grow because the margin for error is less.

Regulators want to see that too, with greater accountability for ‘risk taker’ bonuses which need to be tied more closely to longer-term results. Underwriters will need to have more confidence over pricing and margin to ensure they don’t endanger their company balance sheets.

ILS responds to wider forces

Underwriters must also evolve from simply looking at their lines of business and take a careful look at the wider macro forces at work that will impact the behaviour of capital in the sector. ILS capital really began to grow in earnest in 2006, but acceleration occurred post-2011 after the Tohoku earthquake in Japan. However, having built their approach to investing on the confidence of catastrophe model outputs, underwriters and investors alike have been on the receiving end of losses from lesser-understood zones and perils. In a climate of rising interest rates, rising inflation and other economic factors, investors may be persuaded to take their money elsewhere, most likely back into more conventional asset classes.

All these things matter more to the capital coming into the space because they are looking at reinsurance as an alternative place to put their bet. If the risk-adjusted pricing and the uncertainty that’s in the insurance market right now doesn’t provide enough long term margin, then theoretically they should demand higher rates.

Underwriters must evolve from simply looking at their lines of business and take a careful look at the wider macro forces at work that will impact the behaviour of capital in the sector.

A flat market cannot remain

Whatever happens, for the health of the market, a flattening of the risk-adjusted pricing cycle cannot remain in the long-term. Client differentiation aside, even if the cycle is not as ‘peaky’ as it has been in years gone by, it needs a broader readjustment for the cycle to work; the areas under the peaks need to widen. Although we may not get back to the days where pricing moved as steeply – and black swans aside – upwards momentum in pricing that represents a fair game with clients can be sustained for the benefit of all.    

Smell of caution

The opportunity to show discipline has arrived. With losses outside of expectations, caution is in the air and, to this writer at least, caution smells like a re-evaluation of the insurance cycle as the market collectively changes where it thinks the baseline for rate adequacy lies, and therefore the margin needed for the market to successfully trade forward. There are enough indicators to say the market cycle shouldn’t fail the industry. To do that, the participants need to be patient, appreciate the wider factors at work, and act together.