Global reinsurance pricing was up by low-to-mid single digits on average in aggregate, in line with what S&P Global Ratings had projected after the 2019 midyear renewals. Similar to previous years, it was a late January renewal season, with jostling until the very end, but nevertheless orderly. In general, there was no reinsurance capacity constraint but neither was it cheap or easily available in certain cases. We continue to characterize the overall reinsurance market as firming, with pricing dynamics varying by region, line of business, and cedant's performance--some disappointed and others surprised in a good way. In a nutshell, reinsurance pricing showed signs of revival in the U.S. casualty lines compared with just a satisfactory tone in the overall property lines.

In general, overall reinsurance pricing is improving because views of risks are changing and risk appetites are adjusting while the sector still faces secular headwinds. The 2019 natural catastrophe loss year was below the past 10-year average, but climate change and modelling credibility have dominated recent industry discussions. We expect the industry will carry some of this positive pricing momentum into the upcoming major renewals, notably in Japan in April and in Florida in June. In addition, the constrained retrocession capacity, caused by trapped collateral due to catastrophe losses and loss creep, will continue to exert its influence on hard pricing in the retrocession market. Based on discussions with major reinsurers and market intelligence, we believe the alternative capital level during this year's January renewals was flat as it stabilized from the declines witnessed in the first quarter of 2019. Furthermore, alternative capital providers and investors are increasingly scrutinizing their relationships with asset managers and reinsurers because of subpar returns over the past few years.

Against this backdrop, S&P Global Ratings has a stable outlook on the global reinsurance sector and on the majority of the reinsurers it rates. We base this mainly on reinsurers' still-robust capital adequacy and relatively disciplined underwriting so far, supported by well-developed enterprise risk management and an overall improving reinsurance pricing environment.

Natural Catastrophe Losses Were Below Average In 2019

According to Swiss Re Institute, total economic losses from natural catastrophes in 2019 declined 20% to $133 billion from $166 billion in 2018. Similarly, global insured natural catastrophe losses dropped 41% to $50 billion from $84 billion in 2018 and were below the annual average of $67 billion over the past 10 years. In addition, in recent years, small and midsize loss events (secondary perils such as wildfires and floods) accounted for more than 50% of total insured losses.

In late August and early September 2019, Hurricane Dorian made landfall in the Bahamas and North Carolina, respectively, which caused insured losses of $4.5 billion. In addition, in the second half of 2019, typhoon activity in Asia pushed overall insurance losses higher after a benign first-half of the year. In mid-September, Japan was hit by Typhoon Faxai with $7 billion in estimated insured losses and in early October, Typhoon Hagibis made landfall, causing $8 billion in insured losses according to Swiss Re Institute.

In addition to the catastrophe events of 2019, the sector is still dealing with the adverse loss reserve developments from previous year events. The reinsurance industry's underwriting results experienced loss creep from Hurricanes Irma (which hit the Caribbean and Florida in August and September 2017), Maria (which hit the Caribbean and North Carolina in September 2017), and Michael (which hit the Caribbean and Florida in October 2018). Furthermore, Typhoon Jebi (which hit Japan in September 2018) reserves developed unfavorably in 2019; industry-estimated insured losses more than doubled from their initial estimate and reached about $15 billion.

Despite the 2019 below-average catastrophe year, over the past decade, natural catastrophe insured losses increased in frequency and severity. Losses emanated from both primary (hurricanes, earthquakes) and secondary perils (wildfires, floods). In addition, urbanization, increasing coastal population, and economic asset density, which are close to or encroaching on the wildlands (commonly referred to as wildland-urban interface), have contributed to the magnitude of the catastrophe losses.

The scientific community is confident on climate change's effects on extreme weather. In other words, the broad consensus is that climate change has influenced, and will influence, the intensity and frequency of these catastrophic events. As a result, challenges persist in understanding, modelling, and pricing for climate change and, ultimately, its acceptance by various stakeholders.

Alternative Capital: Smoothing Out The Bumps

Alternative capital, which includes collateralized reinsurance funds, insurance-linked securities (ILS), sidecars, and industry loss warranties, still plays an integral part in the global reinsurance market despite its recent decline. In the first nine months of 2019, alternative capital in the reinsurance market decreased for the first time since the 2008 financial crisis as reported by AON PLC. However, we believe the pullback is just a blip in a prolonged period of greater influx and influence from nontraditional third-party capital sources. While alternative capital accounts for about 20% of total property-catastrophe reinsurance capacity, it provides more than 75% aggregate retrocession capacity. Therefore, its influence on reinsurance and retrocession pricing can't be understated.

According to AON PLC, alternative capital totaled $93 billion at the end of the third quarter of 2019 and represented about 15% of the $625 billion global reinsurance capital. In the first nine months of 2019, it fell 4%, or $4 billion, to $93 billion from year-end 2018. Most of the decline occurred in first-quarter 2019 as assets under management (AUM) outflow stabilized in the second and third quarters and through the Jan. 1, 2020 renewals. Based on discussions with major reinsurers, we believe the alternative capital level during this year's January renewals was flat relative to the latter part of 2019.

The earlier drop was mainly caused by dismal returns in the past couple of years, loss payments, and loss creep from earlier events, exacerbated by governance issues at certain funds, which triggered investors' redemptions. In addition, the $93 billion of AUM included about $15 billion of collateral still trapped because of recent natural catastrophe events. By some estimates, the trapped capital likely increased to about $20 billion leading up to the January 2020 renewals because of the 2019 catastrophe losses and adverse developments on 2017-2018 events, especially those related to Florida storms.

Flight to quality

The recent slowdown in alternative capital inflows reflects investors' concerns vis-à-vis model credibility, including models for secondary perils such as wildfires, risk selection/underwriting, loss reporting, and reserve setting, and the potential climate change impact on the increase in frequency and severity of natural catastrophes. This has caused a flight to quality, as investors have become more selective and have shifted their attention to well-established sponsors or managers with a better track record, modelling capabilities, clearer underwriting strategies, and stronger reserving practices and governance while asking for higher returns. Indeed, Bermuda-based RenaissanceRe Holdings Ltd. raised additional third-party capital in 2019 in its various ventures including DaVinci, Vermeer, Upsilon, and Medici and its AUM rose significantly from the previous year. This contrasts with other players in the sector, which in general did not have an easy time raising new money.

Catastrophe bonds and the ILS market remain active

According to Artemis.bm, in 2019 catastrophe bonds outstanding and the ILS market reached a new high of $41 billion. However, 2019 new issuance declined by 20% or $2.7 billion to $11.1 billion versus 2018, although 2019 remained the third highest issuance year ever after 2017 and 2018. Everest Re Group Ltd. remains one of the largest catastrophe bond issuers, with $2.9 billion outstanding at the end of third-quarter 2019, under its Kilimanjaro Re Ltd. program. Furthermore, mortgage ILS issuance has significantly increased during the past few years since the first mortgage deal in 2015, and accounted for 41% of total issuance in 2019, with Arch Capital Group Ltd. leading the way through its Bellemeade transactions representing more than half of the issuance. We believe this area of the market will stay active because it has been less affected by recent events and is supported by increasing mortgage ILS transactions. It's worth noting that in the first two weeks of January 2020, $1.1 billion of new catastrophe bonds were issued by Swiss Re, Hannover Re, and RenaissanceRe, which have come back to the catastrophe bond market seeking retrocession coverage, thereby highlighting the constrained traditional retrocession capacity.

Alternative capital taking a pause to recharge

Despite the latest bumps in the road, alternative capital is still vibrant and long-term investors have enjoyed good uncorrelated returns over a longer time. The recent drop also highlights that investors are increasingly scrutinizing this product and, perhaps, that the less sophisticated capacity has exited. In addition, the case for investing in insurance risk to diversify in a low interest rate environment remains valid. As a result, we believe alternative capital backed by long-term investors remains committed to property-catastrophe risk and is here to stay, as it expands to other lines of business such as mortgage and in-force life and annuity blocks. We expect that, once the bumps are smoothed over and the recent losses and unfavorable reserve developments are fully digested, growth will likely resume.

Chart 1

Reinsurance Pricing: The Story Continues

On average and in aggregate, global reinsurance pricing has increased by low-to-mid single digits. There was no reinsurance capacity constraint but it wasn't cheap or easily available in certain cases either. We view the reinsurance market as a hardening market rather than a firm one, with the pricing story varying by region, line of business, and loss experience. However, the overall sentiment is positive, with a consensus view on continuation of pricing momentum through 2020. Only about half of the reinsurance business was up for Jan. 1 renewals, so there is more to come through the course of this year.

The aggregate reinsurance covers were in short supply and expensive, and thus, primary insurers bought more per-occurrence protection, which forced up the pricing on those contracts. Furthermore, there was difficulty in getting full placements, especially in certain U.S. casualty lines. As a result, the primary insurers ended up retaining a bit more on a net basis, which increases potential earnings volatility slightly.

Property rate movement was lackluster

Disappointing but not entirely surprising aptly describes the property January renewal season. Reinsurance property catastrophe pricing was up by 5%, as shown by Guy Carpenter's global property catastrophe rate-on-line index, an improvement from last year but still below where the reinsurers were pushing. Reinsurers hoped for a more broad-based pricing improvement; however, that was not the case and the rate movement varied by cedant's performance and geographies. This outcome highlights the regionalization of reinsurance pricing. While a substantial amount of business was up for renewal, the heavy loss-affected regions of Japan and Florida aren't part of this cycle; hence, the reinsurance sector wasn't expecting a big rate jump.

In the U.S., the historical performance of the renewing national and regional programs determined rate movements. Furthermore, there wasn't much capacity constraint and competition remained elevated, which tempered the rate gains. Pricing was flat to up 5%for large national programs, which didn't suffer from significant catastrophe losses. In contrast, smaller and regional accounts saw a price increase of 5%-20% depending on cedant's loss experience. In addition, there were gains in the property pro rata business owing to the contraction of Lloyd's capacity.

European renewals were disappointing, as the rates, on average, were flat-to-slightly down. Certain players view Europe exposure as diversifying risk, which along with ample capacity and benign catastrophe years that have helped historical performance, kept the lid on pricing gains. The big European reinsurers with significant market share dominate this market, and continue to exert their significant influence on pricing dynamics in their own backyard.

In Asia-Pacific, rates improved significantly in Chinese agriculture, which hasn't performed well. Middle East and Latin America rate movement was flat, except in the Caribbean, where the rates rose by low double digits in view of recent years' catastrophe events, and Chile.

Chart 2

Casualty carries the day with reinsurers banking on primary rate increases

The pricing story was more compelling in the casualty/specialty lines, especially in the U.S. The sentiment was much stronger and more broad-based than in the property lines. Rate increases in the U.S. non-proportional business were substantial and ceding commissions on proportional business were down 1-3 percentage points, although it varies by line of business. Even though the ceding commission reduction doesn't look like much on the surface, reinsurers are primarily banking on the primary insurers pushing substantial rate increases, which will flow through to the proportional reinsurance business.

Primary rates are meaningfully up for general liability, excess casualty, umbrella, directors and officers, errors and omissions, medical malpractice (especially for hospitals), trucking, and accident and health. The contraction of capacity by AIG and Lloyd's, increasing frequency and severity trends owing to social inflation in part caused by large jury awards, elevated risk from the #MeToo movement along with lowering of the statute of limitations, and higher claims settlement for auto and liability are underlying drivers feeding into the trend. In particular, professional liability had a tougher time moving terms as compared with general casualty, resulting in ceding commission movement of 2-3 points and excess casualty rate changes in the double digits. Even for workers' compensation, where the primary rates are declining, reinsurance rates were up.

International casualty business didn't see much underlying rate change because by and large performance has held up well but there are signs of a firming environment where adverse trends are emerging. The focus was more on pushing reinsurance rate increases. There was underlying tension in pricing, with some placements being worked late into the cycle, which bodes well for the next renewals. Continental Europe was flat to down depending on the performance, except for pockets of motor and professional lines business, which was slightly up. U.K. motor rates were up due to negative Ogden rates, as well as for excess casualty business. In view of AIG's and Lloyd's corrective underwriting actions and dismal performance, rates also have been hardening in the specialty businesses including marine, hull, aviation, engineering, cargo, and energy. Asia-Pacific's and Latin America's experience was flat from a rate perspective.

U.S. mortgage reinsurance conditions remained stable during the January renewals, although this business renews throughout the year. The pressure on reinsurance rates is due to the tighter spreads government-sponsored entities (GSEs; Fannie Mae and Freddie Mac) get on their business placed in the capital markets, but reinsurers have been able to hold off. Even though the business is past the credit cycle peak, mortgage portfolio quality remains strong and its performance remains better than pre-2008 financial crisis levels. Therefore, the business line should keep producing strong returns despite pressure on pricing and a slight decline in credit quality. This market is well served from a capacity standpoint. Although Munich Re entered this business in 2018, the market remains dominated by U.S.- and Bermuda-based re/insurers. With talks of government plans for GSEs to exit conservatorship, additional mortgage reinsurance risk could be placed in the commercial market, which will push up demand and potentially attract new players.

Retrocession market supply-demand equation remains imbalanced

Alternative capital is more prominent in the property-catastrophe retrocession market than in the reinsurance market. As a result, trapped capital and the decline in alternative capital in 2019 have resulted in constrained retrocession capacity, which drove up pricing 20%-30% on aggregate covers versus 15%-25% on occurrence covers during the January renewals. In addition, terms and conditions were tighter and more rated carriers provided occurrence covers. This imbalance has also affected business writings within the collateralized reinsurance and sidecar segments of the market.

What Lies Ahead?

We expect significant rate increases for the upcoming Japanese and Florida renewals, which should help the sector improve its risk-adjusted returns:

• Japan: The rates reinsurers got in April 2019 were first of the multiyear rate increase for Typhoon Jebi losses. However, with additional typhoons in 2019 and Jebi-related adverse loss developments, the rate conversations will begin significantly higher than those achieved in April 2019, which were in the 15%-25% range. Reinsurers will likely push for more rates up front than spread out over a multiyear period.
• Florida: This market is facing a dislocation, which could support double-digit rate increases. The second half of 2019 saw material developments in Hurricanes Irma- and Michael-related losses. Even though these losses will be taken mostly by Florida mono-state and regional carriers and the state catastrophe fund (a large reinsurance buyer), they still hit re/insurers and contribute to the negative sentiment. Florida is a peak zone exposure for many reinsurers and a large market for alternative capital. In view of multiyear pain and a shift in views of risk, both traditional and alternative capital have higher return targets.
• Casualty: Lack of cross-subsidization from the property-catastrophe business, low interest rates, and adverse loss trends in many lines will keep the pressure up. While the reinsurers will continue to bank on the rate increases being pushed on the underlying business by the primary insurers, there will be a strong effort to lower ceding commissions, tighten the terms and conditions, and achieve higher and adequate returns.
• Retrocession: Reinsurers retained more risk considering the retrocession pricing and scarcity of aggregative covers. As the midyear renewals go through, there's a good possibility reinsurers will be back with higher demand to cover some of their exposures and might seek some relief via the catastrophe bond market. In any case, retrocession capacity will remain dearer.

That said, the level of rates that can be achieved will depend on the balance (or rather, the imbalance) of supply-demand. Heightened competitive pressures and restart of growth in alternative capital could somewhat cap the rate increases.