When analyzing the global reinsurance sector, S&P Global Ratings reviews operating performance on a multiyear basis rather than a single year's results because of the nature of the business, which can result in elevated losses for any given year. The industry struggled to earn its cost of capital (COC) in 2017 and 2018, and barely did so in 2019. Reinsurance pricing reacted in 2019 leading up to the January 2020 renewals, but price increases were mostly in the U.S. and Japan, confirming the regionalization of pricing trends. So entering 2020, the expectations were that this year the reinsurance caravan was set on the right route and reinsurers would improve their results. However, COVID-19 losses and the ensuing market volatility became the straw that broke the camel's back.

Once again, the sector will not earn its COC this year, bearing in mind it has struggled in the past three years to do so due to large natural catastrophe losses, adverse loss trends in certain U.S. casualty lines, and fierce competition among reinsurers exacerbated by alternative capital. Therefore, on May 18, 2020, we revised our outlook on the global reinsurance sector to negative from stable, as we believe business conditions are difficult. Our negative outlook is an overall indicator of credit trends over the next 12 months including distribution of outlooks on ratings, existing sectorwide risks, and emerging risks. Therefore, our negative outlook indicates that we expect to take additional negative rating actions on reinsurers over the next 12 months. As of Aug. 31, 2020, 17% of ratings on the top 40 reinsurers carry a negative outlook (see charts 1 and 2).

In his 2007 book, "The Black Swan," Nassim Nicholas Taleb coined the term "a black swan event" for an unpredictable catastrophic event. Whether the pandemic is a black swan event or not, in the first six months of 2020, the top 20 global reinsurers reported COVID-19 losses of about $12 billion, which are an earnings event for the industry on a stand-alone basis. Combined with other insurance losses, notably natural catastrophes and capital market volatility including investment losses, the sector could swing to a loss for the year. Thus, the sum of these losses could become a capital event for the sector in 2020. We have revised our 2020 P/C combined ratio expectation for the top 20 global reinsurers to 103%-108%, including a natural catastrophe load of 8-10 percentage points (pps), reserve releases of 2-3 pps, and COVID-19 impact of 6-8 pps, as well as an ROE of 0%-3%.

The reinsurance sector remains well capitalized, with the top 20 global reinsurers' capital adequacy still redundant at the 'AA' confidence level at year-end 2019. This cohort of companies raised close to $10 billion in capital this year, some of it to prefund upcoming maturities, and the rest is incremental capital. Most reinsurers halted their share buybacks to bolster their balance sheets once COVID-19 became a real threat. In addition, there is a formation of a couple of start-ups that would like to capitalize on the hardening reinsurance pricing.

Alternative capital capacity, especially collateralized reinsurance, will remain constrained in the near term as alternative capital providers are reeling from their capital being trapped for four years in a row and its underperformance over the past few years. Furthermore, the concerns regarding any potential leakage from business interruption into property coverage, in addition to potential opportunities in other asset classes will likely affect capital providers' appetites.

Overall reinsurance pricing has been hardening during the past 18 months, with tightening terms and conditions, further supported by COVID-19 losses. Reinsurers were already dealing with adverse loss trends in U.S. casualty and certain specialty lines, which might be exacerbated by the pandemic-induced stresses and the increasing frequency and severity trends owing to social inflation. COC has increased and retrocession capacity is expensive. Investment income is bound to suffer over the next couple of years as portfolios face lower-for-longer interest rates, higher credit losses, and increased credit migration. Therefore, higher technical underwriting margins are needed to make up for the shortfall in investment income and for insured losses, which we believe will carry the positive pricing momentum into 2021.

We recognize the high degree of uncertainty regarding the rate of spread and peak of the coronavirus outbreak, and the potential for a second wave in the fall. There is also uncertainty around the shape of the recovery, how the economy and consumers will react to various stimuli, and whether we will revisit market lows and volatility that we saw in March of this year. Furthermore, the risk of legal, regulatory, and legislative intervention that redefines coverage terms remains an overhang on the sector in the short term.

Chart 1

Chart 2

Reinsurers Are Debating Whether The Pandemic Is A Black Or A White Swan

According to Johns Hopkins University, total global COVID-19 cases reached 25.4 million at the end of August 2020, with about 850,000 deaths in 188 countries and regions. Given the rapid propagation of COVID-19 globally, some industry experts rushed to label the pandemic as a black swan. However, Mr. Taleb argues that COVID-19 isn't a black swan but reveals the fragility of our systems. In contrast, the Sept. 11, 2001, attacks are viewed as a black swan.

Indeed, the world has witnessed many pandemics throughout millennia. It experienced at least four pandemics/epidemics as recently as in the past two decades: Ebola (2014-2016), MERS (2015), Swine Flu (2009), and SARS (2002-2003). So clearly, pandemics aren't rare. The world has become a global village aided by low-cost international air travel, which has exacerbated the exponential spread of the virus. This time, the economic impact may have been more dramatic because of the increased interconnectivity and interdependence of our global systems as well as the unexpected and rushed lockdowns.

In the first half of 2020, the S&P Global Ratings' cohort of the top 20 global reinsurers recognized about $12 billion in COVID-19 losses or about 6 pps on the combined ratio based on annualized earned premiums. These booked figures are mostly incurred but not reported losses representing first-order impacts from the outbreak, and include event cancellation, (contingent) business interruption, aviation, directors and officers, errors and omissions, credit including surety and mortgage, mortality, travel, and workers' compensation. We believe additional direct and indirect COVID-19-related losses could emerge over the coming quarters.

A potential rise in corporate defaults will 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, the impact will vary by region and depend on policy language. Most standard business interruption and aviation policies only cover losses from physical damage events--excluding infectious diseases. For example, U.S. policies for the most part exclude communicable diseases. For business interruption in the U.S., there could be legislative attempts to retroactively expand insurance contract coverage. We believe that such efforts would be unsuccessful, unless the government provides resources to insurers to meet these obligations.

Outside of the U.S., there is an element of uncertainty about whether 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 coverage. 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. Furthermore, we expect loss adjustment expenses (LAE) to increase with a rise in litigation.

Chart 3

Reinsurance Renewals Indicate A Firming Market, But Not Necessarily A Hard One Yet

The sentiment for rate increases had been in place for the past 18 months or so due to the confluence of many factors, but the 2019 reinsurance price rises lagged those in the primary insurance and retrocession markets. As a result, reinsurers expected pricing to rebound coming into 2020, with a major pick-up seen during midyear renewals, which were promising although somewhat below what the sector had hoped for. Despite the risks from COVID-19 becoming prominent, pandemic-related considerations didn't really start to fully factor in until June renewals, which gave a further boost to pricing.

During the January renewals, global reinsurance pricing saw an aggregate increase in the low-to-mid single digits but it was not an across-the-board increase, with pricing dynamics varying by region, line of business, and cedents' performance. While property and property-catastrophe price increases were satisfactory at best, a more promising aspect of the renewals was the revival in U.S. casualty pricing, albeit still insufficient, which in the past had been characterized by subsidization from U.S. property-catastrophe business.

April renewals are primarily Asia-Pacific centric with Japan being the largest market. Due to large losses from Typhoons Jebi, Hagibis, and Faxai, and related adverse reserve developments, reinsurers had been reaching out to their cedents much in advance of the renewals. In the end, pricing for wind and flood exposures rose by up to 50% on loss affected business but it left some reinsurers hoping to get to a quicker payback somewhat disappointed. This market is largely served by traditional capital and there wasn't much of a capital constraint, which may have tempered price gains. While most of the reinsurers retained their participation, the market shares shifted slightly to the large European reinsurers, as they upped their participation while a few North American reinsurers pulled back.

Florida June renewals experienced dislocation. The renewals were completed, but it wasn't smooth sailing. Limits were taken out of the market. For instance, the non-renewal of the Florida Hurricane Catastrophe Fund limit of $920 million and $560 million limit reduction by Citizens, Florida insurer of last resort. But, even with the reduced demand, the rates were significantly higher. Unlike in previous years when alternative capital led on pricing, this year traditional reinsurers drove pricing for a change. Traditional reinsurers dealing with higher losses, constrained alternative capital capacity, and higher retrocession costs, pushed hard for higher rates as the pandemic added another concern to the list. The rate increases averaged 25%-35% but the range was much broader (in some cases up to 80%) depending on the loss experience and cedents' ability to manage LAE. Terms and conditions also improved, with pandemic and cyber exclusions put in and LAE caps included to reflect the adverse developments on Hurricanes Irma and Michael losses due to assignment of benefits issues. Despite the magnitude of rate increases, the reinsurance sector's net exposure to Florida is relatively down from the previous year.

Finally, the July renewals saw similar upward pricing trends depending on the region, cedent, and line of business. However, outside of the U.S., rate increases were relatively subdued but positive, a change from historical trends. In a nutshell, overall reinsurance pricing has been hardening with tightening terms and conditions, further supported by the outbreak losses, which will carry the momentum into 2021.

Capitalization Remains A Strength

The reinsurance sector benefits from robust capital adequacy, which remains a pillar of strength for most reinsurers. This strength softens the potential blow from the severity risks that the industry is exposed to. For example, natural catastrophes, long-tail casualty reserves, and pandemics, just to name a few, are risks that reinsurers assume in their underwriting operations. The reinsurance industry often serves as a backstop for the primary insurance market. Therefore, to cope with these severity risks and the ensuing volatility, global reinsurers tend to be strongly capitalized with generally conservative investment strategies.

The top 20 global reinsurers' capitalization strengthened in 2019 and was 8% redundant at the 'AA' confidence level relative to 5% in 2018, because of a strong capital market recovery. This cohort lost their capital redundancy at the 'AAA' confidence level in the past three years because of record catastrophe losses in 2017 and 2018, adjustments to the large global reinsurers' asset liability management and longevity risk capital charges, share buybacks, and special dividends.

Chart 4

Given the extreme turbulence in the capital markets earlier this year and the uncertainty around COVID-19 losses, reinsurers have halted their share repurchases, a few have curtailed their dividends due to regulatory guidance, and many have raised capital that totaled close to $10 billion year-to-date, to bolster their balance sheets, with some aiming to take advantage of more favorable reinsurance pricing. This capital took the form of debt, hybrids, and even common equity, which should cushion against what seems to be an active catastrophe year. We believe capitalization will remain a strength for the sector in the next two years, but could be tested again by market volatility.

Chart 5

As rate increases are booked, and earned, through income statements over the upcoming quarters, this should improve the accident-year loss ratios. However, because of the confluence of COVID-19 losses, adverse loss trends notably in U.S. casualty lines, and natural catastrophe claims, we forecast an underwriting loss for the industry in 2020 with a combined ratio of 103%-108% for the top 20 reinsurers and an extremely low ROE of 0%-3%. Although we expect some COVID-19 losses will emerge next year, the earnings picture will likely improve in 2021 as reinsurance rate increases are earned, and assuming COVID-19 losses are contained within the current aggregate estimates.

Table 1

The Industry Has Struggled To Earn Its Cost Of Capital And 2020 Doesn't Look Promising

The global reinsurance sector's track record of earning its COC has been weak. Similar to 2017 and 2018, 2020 will be another year when reinsurers will struggle to meet their COC. In 2017 and 2018, the reinsurance sector generated an ROC of only 1.5% and 2.9% below its 7.2% and 7.8% COC, respectively (defined as the weighted-average cost of capital). The impact of 2017 and 2018 natural catastrophe losses, loss creep, and investment market volatility in fourth-quarter 2018, all played a significant part in these results.

The improved investment returns in 2019 helped the sector barely earn its COC. This meant that the gap between the sector's actual ROC and COC was a positive 0.9%. In the first half of 2020, the sector took a hit from COVID-19-related losses, significantly lower net investment income relative to the previous year, overall capital market volatility with declining equity valuations, and spread widening. However, the capital markets' surprising quick recovery after the first quarter through the end of August has provided some, perhaps temporary, relief to reinsurers. But, credit risk within fixed-income portfolios remains elevated, which will test the sector's investment returns in 2020-2021.

Insurance losses, including COVID-19-related claims, coupled with investment and natural catastrophe losses, reduced the sector's ROC in the first half of 2020 to 2.1% compared with 6.9% in 2019. At the same time, the COC rose to 7.2% from 6.0%, because of higher equity and credit risk premiums, partially mitigated by declining risk-free rates. 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's difficult to project the sector's full-year 2020 earnings because of rising uncertainties, it's unlikely that they will be sufficient to meet the sector's COC. For some reinsurers, which we would consider negative outliers, the 2020 underperformance may become a capital event. Prospectively, we could reconsider our negative outlook on the sector at the point that we believe that the sector may earn its COC, which we don't expect will happen before 2021, at the earliest.

Chart 6

Alternative Capital Backers Are More Selective, While Capacity Remains Constrained

In 2019, alternative capital in the reinsurance market decreased for the first time since the 2008 financial crisis, and the trend has continued in 2020. However, alternative capital, which includes collateralized reinsurance funds, insurance-linked securities, sidecars, and industry loss warranties, still plays an important role in the global reinsurance market despite its recent decline. In general, alternative capital accounts for about 20% of total property-catastrophe reinsurance capacity, but it provides more than 75% aggregate retrocession capacity. Therefore, it continues to exert its influence on reinsurance and retrocession pricing. We believe the pullback is temporary in a prolonged period of more inflow and influence from nontraditional third-party capital sources.

According to AON PLC, alternative capital fell 4.2% to $91 billion at the end of first-quarter 2020, from year-end 2019, and represented about 15.4% of the $590 billion global reinsurance capital. Based on discussions with major reinsurers, we believe the $91 billion of assets under management included about $20 billion of trapped capital as collateral. Investors are still reeling from their capital being locked for the fourth year in a row because of the 2019-2020 natural catastrophe losses, adverse developments on 2017-2018 events, and potential for leakage from business interruption into property coverage due to COVID-19.

The decrease in alternative capital was caused by dismal returns in the past few years, loss payments, and loss creep from earlier events, exacerbated by governance issues at certain funds. These factors, among other things, have triggered redemptions by some investors while others paused to reassess their appetite for insurance risk. Investors also have 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.

During the past 18 months, it seemed that alternative capital ran out of steam, but the case for investing in low-correlated insurance-linked assets 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, further supported by hardening reinsurance pricing. However, this hypothesis could be tested if additional collateral is trapped while other asset classes may offer higher returns.

Alternative capital has expanded to other lines of business such as in-force life and annuity blocks, and has become a vital risk transfer instrument for U.S. private mortgage insurers. Year-to-date catastrophe bonds issuance has been healthy and we expect it will remain so during the remainder of 2020 and into 2021, aided by the dislocation in the retrocession market. We believe that once the dust settles and the losses are fully digested with greater visibility around COVID-19 losses, alternative capital will likely renew with growth.

Chart 7

Life Reinsurers Are Facing Higher Mortality Losses, But The Impact Is Manageable

The life reinsurance sector has not remained unscathed by the pandemic, with the top 20 global reinsurers reporting about $1 billion of COVID-19-related underwriting losses in the first half of the year. Underwriting losses arise mainly from a higher mortality rate due to the outbreak, with the majority of the losses from the U.S. However, the ultimate losses will depend on the actions of governments and society at large to control the spread, which will influence the mortality, longevity, and morbidity experience. This also highlights the sector's sensitivity to key actuarial assumptions related to these business lines including correlation. However, compared with the P/C reinsurance sector, life reinsurance is less affected, we believe. Despite the negative impact from COVID-19, we believe the life reinsurance sector continues to benefit from strong credit fundamentals and helps with diversification benefits for multiline reinsurers. While the operating performance will weaken in 2020, we still expect an ROE of 4%-6% in 2020 relative to 10.2% in 2019. With the expected economic recovery in 2021, the ROE will likely improve to about 10%.

In general, with its high barriers to entry and fewer global players, life reinsurance is less price sensitive relative to P/C. Reinsurance buyers are sophisticated, precluding the need for intermediaries, and demand is less driven by available capacity and more by balance-sheet management. We have also observed an increasing demand for financially motivated reinsurance for capital relief amid the hike in reserve provisions caused by low interest rates. The U.S. is the sector's biggest market, with 40% market share of global premiums with stable cession rates from primary insurers. The U.K. longevity business continues to see strong demand. However, we believe the industry's future growth will mostly come from Asian markets, specifically, emerging markets, which are experiencing increased insurance penetration supporting robust growth of primary life business. Mergers and acquisitions and alternative capital aren't transformative in this space. Therefore, we think the competitive landscape will remain largely stable over the next few years.

Chart 8

Foggy Conditions Ahead

There is no playbook for the conditions reinsurers find themselves in. Although the reinsurance sector is adept in dealing with multiple large catastrophic events, the current state of affairs is producing additional stresses and uncertainties. Unfortunately, reinsurers are facing the pandemic at a time when the tide was turning on the soft pricing cycle. In dealing with COVID-19 losses, the resultant stresses may expose weaknesses of the past in a more severe way, dealing a blow to some reinsurers.

Reinsurers that stuck to their knitting through the soft cycle and were prudent in their approach to underwriting are in a better position to navigate the current environment. Pricing is no panacea if the adverse trends continue to pile on, and that is where the uncertainty reigns. Some reinsurers may be tempted to play to the pricing in the absence of clear loss trends, but if there is one thing that is certain in this environment, it's uncertainty. Therefore, we expect underwriting conditions will tighten with pricing momentum firmly in place as the 2021 reinsurance renewals approach.

Related Research

• Top 40 Global Reinsurers And Reinsurers By Country: 2020, Sept, 8, 2020
• Global Reinsurers Face Threat If COVID-19 Losses Are Followed By A Major Catastrophe, Sept. 8, 2020
• Turning The Supertanker: Underwriting At Lloyd's Market Changes Course, Aug. 20, 2020
• COVID-19 Pushes Global Reinsurers Farther Out On Thin Ice; Sector Outlook Revised To Negative, May 18, 2020
• COVID-19 Market Volatility Tests North American Reinsurers' Resilience, April 17, 2020
• U.S. Casualty Reinsurance Pricing Revives During The January 2020 Renewals, Jan. 15, 2020