In view of current heightened market volatility, S&P Global Ratings conducted its investment assets stress tests for the North American (Bermuda, Canada, and the U.S.) reinsurers. The results show that the significant majority of our rated North American reinsurers are able to maintain capital adequacy in line with our ratings on them. Even those that have felt the pinch and saw capital adequacy dip and become deficient, as of year-end 2019 on a pro forma basis, will likely be able to replenish their capital over the next two years (2020-2021). On the other hand, if the COVID-19 pandemic becomes a capital event rather than an earnings event for the few negative outliers, we will likely take rating actions if we believe that they won't be able to rebuild their capitalization through earnings retention and capital management strategies over the next 12 to 24 months.

During the third week of February 2020, the COVID-19 pandemic led to one of the steepest and fastest declines in the history of the U.S. stock market. This has triggered a significant jump in the financial markets' volatility, with investors having nowhere to hide. As a result, the Chicago Board Options Exchange's Volatility Index, or VIX, reached an all-time high of 82.69 on March 16, relative to 12.47 where it started the year, and closed at 53.54 on March 31. Similarly, between Feb. 19 and March 23, the S&P 500 index saw a peak-to-trough drop of 33.9% and ultimately was down 20.3% for the quarter.

Adding to the global economic shock is the oil price war between Saudi Arabia/OPEC and Russia regarding production cuts to stabilize the pricing freefall. At the same time, among other actions, the Fed slashed interest rates to near zero to support the U.S. economy. As a result, the 10-year U.S. Treasury yield dropped to 0.70% at the end of the quarter from 1.88% at the start of the year, while falling to an all-time low of 0.54% on March 9 as investors sought the safety of U.S. government bonds, contributing to corporate credit spread widening. Of greater importance, the U.S. Congress passed a historic $2.2 trillion stimulus package as a shot in the U.S. economy's arm to help small businesses and essential industries weather the current economic disruption.

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Market Volatility: All Eyes On Capital As Risk Dashboards Light Up

Given the extreme turbulence in the capital markets, we reviewed North American reinsurers' ability to weather the hit to their investment portfolios under stressed conditions. In doing so, we not only took account of their investment risk profiles such as asset allocation and sector diversification, fixed income credit quality and duration, but also considered their ability to recover their capital adequacy position over the next 12-24 months. This testing primarily focused on the asset-side stress and the implications for prospective capital position assuming normalized earnings; or in other words, our base-case scenarios. However, we are cognizant of the challenges reinsurers also face on the underwriting side, which would hamper their business prospects and earnings. For instance, the outbreak exposes North American reinsurers to potential losses from aviation, travel insurance, credit insurance, contingent business interruption, event cancellation, mortgage reinsurance, and mortality risk. In addition, they could see spillover to other lines of business such as errors and omissions, as well as directors and officers. These aspects are not in scope for the purpose of this exercise. We estimate that our 2019 base-case risk-adjusted capitalization of the North American reinsurers prior to the stress test was supportive of our ratings. The box below and Table 2 outline our testing approach and assumptions.

Table 1

The capital stress test dashboard in table 1 highlights our estimates of reinsurers' capital adequacy for 2019-2021 relative to the minimum required levels to support our ratings. We estimate that the stressed investment valuations would be lower by about 7.7%, on average, for the cohort of 13 reinsurers we rate. However, the impact varies depending on investment risk appetites. At the high end, Berkshire, Fairfax, and Markel are experiencing greater declines in their portfolio values compared with those of Fidelis, RenaissanceRe, AXIS, and Lancashire, which are at the lower end.

Undoubtedly, capital positions take an immediate hit with most reinsurers facing deficiencies at the required capital levels needed to support the ratings as of year-end 2019 on a pro forma basis. While most of the reinsurers recover their capital positions and can bear the investments' stress for now, the path and the time it takes to recover depend on many factors. On the macroeconomics level, the shape of the recovery will influence the reinsurance business conditions and the demand side of the equation, as some of the economic output could be permanently gone. On the microeconomics level, it will be based on the strength of a reinsurer's starting capitalization, the risk profile of its investment portfolio, its underlying earnings power, and management's ability and strategies taken to preserve and shore up capital over the next 12-24 months.

Despite the right side of our capital stress test dashboard turning green for the significant majority of reinsurers by 2021, the capital buffers we have become accustomed to would deplete and the capital positions would remain too close for comfort. With global economies in recession and reinsurance losses arising from COVID-19, reinsurers are facing an environment where uncertainty reigns, and the decline in capital resiliency could lead to more rating actions over the next 12-24 months. While we continue to monitor the sector, recently, we took the following rating actions:

• Fairfax Financial Holdings Ltd.: On April 3, 2020, we revised our outlook to stable from positive to reflect our view that over the next 12 months, the company is unlikely to achieve a higher level of capitalization required to support a higher rating. However, we continue to believe the current rating is well supported by Fairfax's diversified business profile and strong capitalization.
• Arch Capital Group Ltd.: On March 26, 2020, we revised our outlook to negative from stable, reflecting the risk to the company's earnings and capitalization from the mortgage insurance business. In our asset stress test, the company is able to maintain our expected capital range of 5%-10% deficiency at the 'AA' confidence level by 2021, but our base case shows a heavy reliance on earnings from the mortgage insurance segment. Despite the deficiency at the 'AA' confidence level, our group capital model incorporates severe mortgage-related stress loss estimates that are higher than those experienced by the primary mortgage insurers for a similar risk profile during the 2008 U.S. financial crisis.

We believe that Argo Group International Holdings Ltd. could be pressured in maintaining its capital position under the stress scenario despite the material de-risking of its investment portfolio in fourth-quarter 2019. The negative outlook captures the risk to Argo's capital position along with our pre-existing views about risks to its performance and its governance. The company is undertaking strategic actions to improve the performance of its international business, and strengthening its governance.

On March 3, 2020, we revised our outlook to positive from stable on PartnerRe Ltd. after the announcement of its sale by its parent, EXOR N.V. (BBB+/Positive), for $9 billion in an all-cash transaction to France-based mutual insurance Covea group (AA-/Stable). We believe that subsequent to the acquisition, PartnerRe could benefit from stronger support as part of a higher-rated group with a strong balance sheet.

Table 2

Investment Risk Appetites Come To The Fore

In general, the North American cohort of 12 reinsurers' (excluding Berkshire) investment portfolios are well diversified and conservatively managed, with 67.3% of total invested assets at year-end 2019 allocated to investment-grade fixed income securities, 8.5% to cash and cash equivalents, and 24.2% to risky assets. These risky assets incorporated non-investment-grade bonds, public equities, and alternative investments including hedge funds, private equities, real estate, and other risky assets.

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On one end of the spectrum, Fidelis, RenaissanceRe, AXIS, and Lancashire have conservative investment strategies compared with those of Berkshire, Fairfax, and Markel; the latter three are more aggressive, on the other end of the spectrum. Lancashire and RenaissanceRe have risky asset exposure of less than 15% of their portfolios at year-end 2019, as they try to balance the higher volatility on their property-catastrophe business. In addition, AXIS has been de-risking its investment portfolio. However, Fidelis has virtually no exposure to risky assets. Although the company began its operations as a total return re/insurer, its investment risk significantly decreased following its strategic decision in mid-2017 to move away from hedge funds and into plain vanilla fixed income as it found the high-risk asset strategy incompatible with its long-term objectives.

On the other hand, Berkshire is an outlier, with 74.7% of its re/insurance group $326 billion invested assets at year-end 2019, almost entirely allocated to the U.S. equity market. Berkshire's re/insurance group has $240 billion invested in U.S. blue chip companies with the top five holdings at year-end 2019 included Apple $73.67 billion, Bank of America $33.38 billion, Coca-Cola $22.14 billion, American Express $18.87 billion, and Wells Fargo $18.6 billion. However, Berkshire holds 20% in cash and cash equivalents totaling about $65 billion, which partially mitigates the risk from equities, and provides more than ample liquidity. In this analysis, we did not account for additional assets and earnings accessible to the parent, Berkshire Hathaway Inc.

Berkshire has a unique business model and places emphasis on generating float, which the holding company has successfully deployed over the years in acquiring non-insurance operations and public equities, primarily held by its re/insurance companies. Similarly, Fairfax and Markel have a large appetite for investment risk, with 37.3% and 34.1%, respectively, of their portfolios allocated to risky assets. Both of these entities, in addition to Alleghany, resemble the Berkshire business model, although on a smaller scale.

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COVID-19 Wreaks Havoc On Reinsurers' Valuations

The sudden shock to the global economy due to the containment measures undertaken following the COVID-19 outbreak has brought significant volatility to the global financial markets. As a result, the stock prices of the publicly traded North American reinsurers nosedived in first-quarter 2020. The impact was material as their average stock price dropped 28.6%, while their average price-to-book value multiple also dipped 28.8% to 0.95x on March 31, 2020, from 1.34x on Dec. 31, 2019.

In the first quarter, Argo, AXIS, and Arch were laggards, with their stock prices falling 44.7%, 35.0%, and 34.4%, respectively. At the same time, Markel, Berkshire, and Lancashire stock prices fell about 20%. At the end of the quarter, about half of the North American reinsurers traded below their book values. In contrast, Lancashire and RenaissanceRe led the other half and still traded at a premium relative to their book values, 1.39x and 1.24x, respectively. This could be partly explained by the relative conservative investment strategies adopted by these companies, and relatively higher proportion of uncorrelated property-catastrophe exposure, making these companies somewhat less susceptible to COVID-19 fallout.

Despite the current low valuations providing ample incentives for North American reinsurers to pursue share buybacks, we believe it would be imprudent to do so. Rather, we think reinsurers should preserve capital to offset the erosion in capital positions due to the current volatility in the financial markets and the potential re/insurance claims from COVID-19.

Over the past few years, North American reinsurers have used share buybacks and dividend payouts to optimize their capital. However, share repurchases have materially declined during the past 18 months. This decline is partly attributable to the majority of North American reinsurers trading at a premium relative to their respective book values up to the middle of February this year, when the deepest market correction started since the 2008 financial crisis. In addition, many reinsurers have been focusing on rebuilding their capital levels, which are still recovering from some earnings, and in certain cases capital, depletions from record back-to-back catastrophe years in 2017-2018, and the resulting loss creep in 2019. Furthermore, the positive reinsurance pricing momentum during the latest renewals has provided underwriting opportunities to profitably deploy capital rather than spend it on buybacks. However, reinsurers pursuing aggressive capital strategies such as share repurchases while carrying thin capital buffers could result in negative rating actions.

Table 3

Capital Preservation Is Key In This Time

Overall, North American reinsurers entered 2020 with robust capitalization and brighter market prospects, with firming reinsurance pricing after years in decline supported by relatively disciplined underwriting so far and by well-developed enterprise risk management practices. We believe the investment losses and low interest rates depressing investment yields, along with reinsurance claims due to the outbreak, could further harden reinsurance pricing and maintain the momentum during the upcoming 2020 renewals. In aggregate, this should help the sector partially mitigate some of the risks and uncertainties arising from COVID-19 and the resulting economic contraction.

However, North American reinsurers are carrying thinner capital buffers relative to the past few years because of the current financial market turmoil. Therefore, those with riskier investment strategies and outsize natural catastrophe exposure could be further exposed if 2020 ends up being an above-average catastrophe year, which any additional drops in market values could exacerbate. We believe that in such times, prudence in capital management strategies is key.

Table 4

Related Research

• Fairfax Financial Holdings Ltd. Outlook Revised To Stable From Positive; Ratings Affirmed On Strong Capitalization, April 3, 2020
• Outlooks On Five U.S. Private Mortgage Insurers Revised To Negative Due To Elevated Credit Risk From COVID-19, March 26, 2020
• Argo Group US Inc. Ratings Unchanged Following Announcement Of Charges In Fourth-Quarter 2019, Feb. 12, 2020
• U.S. Casualty Reinsurance Pricing Revives During The January 2020 Renewals, Jan. 15, 2020
• Argo Group US Inc. And Subsidiaries Outlook Revised To Negative From Stable Due To Governance-Related Risks, Nov. 12, 2019