Why rising interest rates won’t, on their own, improve non-life reinsurers’ operational earnings.

Non-life reinsurance pricing has been deemed inadequate by many market practitioners since 2014. While this has hit profitability, it is often seen as only part of the difficult environment for reinsurer earnings, the other factor being depressed investment income levels.

Whilst it is true interest income has been depressed, the argument does not hold water as an explanation for weak overall performance.

At first sight the logic seems entirely reasonable, especially for those reinsurers writing a material amount of casualty business.  Historically low interest rates have meant that investment yields on carried reserves have been historically low too.

The problem with this as an explanation for lower profitability is that it is not causal.  A simple thought experiment illustrates the point: imagine that, for whatever reason, major central bank rates move to a more normal 5% over the next year and we also have a normal yield curve.  Ignoring any wider economic implications of why that has happened, we can be sure of one thing, which is that the pricing of casualty reinsurance would fall.

Expected investment returns are an input into reinsurance pricing models.  In a normally functioning market, if each dollar of premium income is expected to yield more investment income, competition for that dollar increases and pricing drops.

Neither is it really tenable to expect that reinsurers would take the opportunity to hold the line on pricing and finally achieve better profitability through rising yields. Having the ability and willingness to maintain pricing levels in the face of higher expected investment income is no different to raising prices now to reflect inadequate underwriting returns.  And that is not really happening.

Two indirect consequences of higher interest rates also need to be considered.

First, the extent to which this means some of the capital currently deployed in the reinsurance sector (both alternative and traditional) exits due to enhanced opportunities elsewhere.  Materially reduced industry capital would indeed drive higher pricing.  But would it happen?  We doubt it, unless there is a radical realignment of the risk/reward opportunities available to large investors across the investible universe.  And it is not obvious that a more normalised interest rate environment would lead to that (although banks could be expected to become more attractive to investors).

Second, the driving up of reinsurers’ own cost of capital. This could well lead to increased reinsurance pricing but, in itself, would not increase real profitability since that needs to be considered relative to the cost of capital.

A striking observation from S&P in its recent review of the 20 members of its Global Reinsurance cohort is that, despite the 2017 Cat. losses, 2018 pricing levels would on average be expected to lead to returns on capital only just exceeding its cost.  That, S&P highlights, is dramatically different to the impact of the pricing reaction seen in the year immediately after the last two major Cat years (2005 and 2011) when returns on capital spiked well above its cost before trending slowly down again over several years.  Yet the scale of the 2005, 2011 and 2017 Cat. losses were broadly similar.  This tends to suggest that the industry’s competitive dynamics now make it very difficult to reflect more than the cost of capital in pricing, even in response to major Cat. years.  Payback was not able to be priced-in this time around.

But is reinsurance pricing actually too low?  Many would argue that, for the “peak risks” being taken, it surely is.  We just haven’t seen definitive evidence of that as we haven’t had a sufficiently bad Cat. year to prove the point.  Moreover, performance trends over recent years are based on reserving levels that could yet turn out to have been optimistic.  If that proves to be the case in any material way, then the “with hindsight” pricing will clearly have been inadequate.  Yet traditional and alternative reinsurance providers are still willing sellers of cover at current prices.

For now, these remain points of debate.  Either way, any sense that an enhanced investment yield environment is a solution to a sector profitability problem seems very optimistic.  And, short-term of course, bottom line results may well feature mark-to-market losses on bond portfolios.

Stuart Shipperlee
Head of Analysis

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