When it comes to the reinsurance sector's profitability, S&P Global Ratings considers this to be more akin to an endurance race than a 100-meter sprint. For that reason, we focus our analysis on the longer-term view of profitability relative to the cost of capital rather than a snapshot at a single point in time, as the nature of business can result in elevated losses for any given year. In the past three years, the sector has struggled to earn its cost of capital due to large natural catastrophe losses and generally fierce competition among reinsurers exacerbated by alternative capital.

The coronavirus pandemic, with rising property/casualty (P/C) reinsurance claims and falling investment returns, will mean that 2020 will probably be a tough year for global reinsurers. As a consequence, we believe the sector's ability to earn its cost of capital in 2020 has visibly reduced, to almost negligible, bearing in mind the sector still faces the North Atlantic hurricane and Pacific typhoon seasons, with the cost of capital haven risen in first-quarter 2020. Including our assumptions for 2020, we believe the sector will have failed to earn its cost of capital three times within 2017-2020, which will be the worst sequence of results in the past 15 years.

We estimate that COVID-19-related losses in first-quarter 2020 added an additional 10 percentage points on average to the combined ratio of the quarter for the sector. This, coupled with investment losses, have dropped the sector's return on capital to about 3.5% in first-quarter 2020 from 7.4% as of year-end 2019, while the cost of capital increased to about 7.7% at the end of first-quarter 2020, from 5.9% at year-end 2019. We initially estimated a return on equity (ROE) of 7%-9% and return on capital of 6%-8% for 2020, which in our view will no longer be met this year, if the sector experiences a normalized catastrophe loss burden of about 8-10 percentage points of the combined ratio.

We are revising our 2020 aggregate combined ratio expectation for the top 20 global reinsurers to 101%-105% (where over 100% indicates an underwriting loss), including a natural catastrophe load of 8-10 percentage points and reserve releases of 2-4 points (see table 2). We also incorporate 5 points for COVID-19 impact assuming insured industry losses of about $30 billion (which appears to be at the lower end of Willis Re's current estimated range). This is based on an assumption of the top 20 global reinsurers bearing approximately 30% of insured COVID-19 losses, taking into account their market share of the global reinsurance sector. Having said that, we see downside risk to our expectations. We estimate a 2-point hit to the aggregate combined ratio for the top 20 global reinsurers for every $10 billion increment in COVID-19-related insured losses.

Because we generally expect business conditions to have become much tougher for global reinsurers, we have revised our sector outlook to negative from stable. To develop our view of the global reinsurance sector, which is an overall indicator of credit trends over the next 12 months, we analyze the distribution of outlooks on ratings, existing sectorwide risks, and emerging risks. Our negative view therefore indicates we expect to take additional negative rating actions on reinsurers over the next 12 months.

In particular, we could take rating actions on outliers with higher asset risk exposure or large P/C reinsurance COVID-19-related claims that become a capital event and that we believe won't be able to rebuild their capitalization through earnings retention and capital management strategies over the next 12 to 24 months. We will continue to monitor developments closely in this volatile environment and will regularly communicate our views about companies' exposures and their ability to replenish capital in future years, as well as through the upcoming 2020 Atlantic hurricane and Pacific typhoon seasons. As of May 18, 2020, 30% of our ratings on the top 20 global reinsurers either carried a negative outlook or were on CreditWatch with negative implications, with 70% having a stable outlook (see table 4).

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Earnings Are Unlikely To Cover Cost of Capital

The global reinsurance sector's track record for meeting its cost of capital in recent years has not been great. This year, as in 2017 and 2018, will be another where reinsurers will struggle to meet their cost of capital (see chart 1). The sector already took a hit in the first quarter on investments with declining equity valuations and spread widening. Moreover, credit risk within fixed-income portfolios will remain elevated, which will challenge the sector's investment returns in 2020-2021 (see "Fallen Angels Rose Sharply In First-Quarter 2020 Amid COVID-19 And Oil Price Shocks," published Aril 16, 2020). It should be noted that the partial recovery of capital markets after the first quarter has pulled back some of the losses, providing some, perhaps temporary, relief to the reinsurers.

Chart 1

We also believe that COVID-19-related claims on the P/C reinsurance side are rising and started to negatively affect reinsurers in the first quarter. COVID-related losses for the top 20 reinsurers amounted to about 10 percentage points on average of the combined ratio for the quarter. These losses mainly include event cancellation claims but, selectively, reserves set aside for business interruption, directors and officers, credit, and travel, and were mostly first-order impacts from the outbreak. However, there isn't much of a consistency in the figures because the reinsurers recognize the losses using different approaches. We expect additional direct COVID-19-related losses to be recognized in the second quarter, and for indirect impacts of COVID-19 to emerge over the coming quarters.

In first-quarter 2020, the main burden for reinsurers resided in event cancellation or postponement losses, such as postponement of the Tokyo Olympics and the cancellation of other large sporting events--exposures mainly taken by large global reinsurers. But smaller events also add to the bill. In our opinion, apart from these lines of business, other critical lines that will experience higher losses across the globe will include (contingent) business interruption; aviation; credit lines including surety and mortgage, directors and officers, errors and omissions; and workers compensation, in line with expected economic slowdown. As a result of the sharp deterioration in macroeconomic prospects, S&P Global Ratings' economists have significantly lowered our GDP forecasts for the year, and we now see a global contraction of 2.4% before a rebound to growth of 5.9% next year (see "COVID-19 Deals A Larger, Longer Hit To Global GDP" published April 16, 2020).

Moreover, a potential rise in corporate defaults will also hit directors' and officers' policies, which have already been affected by claims inflation in recent years in the U.S. For business interruption and aviation, we believe the sector may be affected, but the magnitude will vary by region and depending on policy coverages. Most standard business interruption and aviation policies only cover losses from physical damage events--excluding infectious diseases, for example. U.S. policies specifically exclude communicable diseases for most part. For business interruption in the U.S., we would expect that a host of constitutional and legal challenges would likely accompany legislative attempts at potential retroactive expansion of insurance contract coverage. We anticipate that such efforts in any state would be largely unsuccessful, unless the government provides resources to insurers to meet such obligations. However, outside of the U.S., there is an element of uncertainty if business interruption claims will be triggered and covered by (re)insurers and may be subject to legal proceedings, particularly for policies with less definitive wordings around pandemic covers. We therefore do not rule out that either regulatory or legal pressure to pay claims may arise with the potential for further volatility for reinsurers. In addition, we expect loss adjustment expenses to register an increase with a rise in litigation.

The insurance losses, coupled with investment losses, have reduced the sector's return on capital in the first quarter of 2020 to about 3.5%, from about 7.4% as of year-end 2019. At the same time, the cost of capital rose to about 7.7% as a result of higher equity and credit risk premiums, partially mitigated by declining risk-free rates. Since first-quarter 2020, the cost of capital has decreased again but remained visibly above the level at year-end 2019. In addition, any constraints on alternative capital, which the sector has come to rely on heavily, will also push up the cost of doing business. While it is difficult to project the sector's full-year return on capital and ROE at this stage, it is safe to say it will not be sufficient to meet the sector's cost of capital, and for some reinsurers it may result in bottom-line losses and become a capital event. However, we might consider revising our negative view of the sector at the point that we believe that it may earn its cost of capital, which we don't expect to be before 2021, at the earliest.

Table 1

Table 2

Higher Reinsurance Prices And Stable Life Reinsurance Earnings Lessen COVID-19 Losses

The global reinsurance sector is benefitting from improvements in P/C reinsurance price trends that started about 18 months ago. We observed a firming trend during January and April renewals this year and expect that momentum to continue for June/July renewals. This comes in response to 2019's natural catastrophe losses, prior years' natural catastrophes loss creep, scarcity of retrocession capacity, flight to quality by alternative capital, and adverse reserve loss trends on certain U.S. casualty business (see "U.S. Casualty Reinsurance Pricing Revives During The January 2020 Renewals," Jan. 15, 2020). While a few lines of business--less affected by the pandemic, such as life reinsurance or motor insurance--can provide some relief, those are unlikely to weigh on the push for additional rates. The global recessionary environment will place pressure on the sector's top line due to business contraction and the reduction in both consumers' disposable income and insured values.

Although difficult to quantify, our assumptions about sound technical performance in life reinsurance remain largely unchanged at this stage, with only limited impact expected from COVID-19 on current mortality rates. Despite the many tragic deaths due to COVID-19, we don't expect the fatalities to materially hurt the technical performance of life reinsurers. Moreover, the reinsurance sector's proportion of exposure to populations of 60 or older (which is observed to have a higher COVID-19 mortality rate) is relatively low. Furthermore, based on modeled results, composite reinsurers' exposure to a 1-in-200 year pandemic is generally much less than the cost of their natural catastrophe exposure for a 1-in-200 year event.

Grueling Prospects And Thinner Capital Buffers

The global reinsurance sector entered 2020 with robust capitalization, which in aggregate surpassed the threshold at the 'AA' confidence level, according to S&P Global Ratings' capital model. However, capital cushions are lower than historical levels in the past five years having taken heavy catastrophe losses of 2017-2018. Then, in the first quarter, capital buffers took another hit due to the outbreak and investment losses. With meteorological forecasts of above-normal activity during this year's Atlantic basin hurricane season and expectations for additional COVID-19-related losses, reinsurers have less room to absorb major natural catastrophes.

The large global reinsurers on average lost about 20-30 percentage points on their regulatory solvency ratios during first-quarter 2020, mainly driven by spread widening and equity market volatility. However, those ratios remained robust, averaging above 200% at the end of the quarter (see table 3). North American reinsurers are also carrying thinner capital buffers than in the past, but even after investment stress testing, almost all rated North American reinsurers are able to maintain capital adequacy in line with our base case rating assumptions for now, not including pandemic-related losses (see "COVID-19 Market Volatility Tests North American Reinsurers' Resilience," April 17, 2020).

Table 3

The global reinsurance sector is facing historically unusual times where a single event is materially disrupting both the asset and liability side of their businesses. There are not many places that provide respite. Therefore, we believe fundamental, disciplined underwriting and risk pricing, tighter terms and conditions with clear exclusions, and overall proper risk management are key if reinsurers are to defend their competitive position, and preserve earnings and capital strength. For a few players that may struggle to navigate these uncertain times, we can expect their creditworthiness to suffer.

Table 4a

Table 4b

Related Research

• In A Correlated Market, Catastrophe Bonds Stand Out, May 18, 2020
• COVID-19 Market Volatility Tests North American Reinsurers' Resilience, April 17, 2020
• COVID-19 Deals A Larger, Longer Hit To Global GDP, April 16, 2020
• Fallen Angels Rose Sharply In First-Quarter 2020 Amid COVID-19 And Oil Price Shocks April 16, 2020
• U.S. Casualty Reinsurance Pricing Revives During The January 2020 Renewals, Jan. 15, 2020