The global reinsurance sector could finally be facing a turnaround, with pricing improvements persisting for most lines while property catastrophe lines are experiencing a full-on hard market environment. The question on everyone's mind, though, is will these pricing improvements be enough to combat the endless barrage of headwinds against the reinsurance sector that have muted returns for years? The combined impact of higher frequency and more severe natural catastrophes, untamed inflation across the world, mark-to-market investment losses eroding capitalization, and the Russia-Ukraine conflict all threaten the reinsurance sector.

As a result, S&P Global Ratings' view on the global reinsurance sector remains negative, reflecting our expectations of credit trends over the next 12 months, including the distribution of rating outlooks, existing sectorwide risks, and emerging risks. As of Aug. 31, 2022, 19% of ratings on the top 21 global reinsurers were on CreditWatch with negative implications or had negative outlooks, 76% were assigned stable outlooks, and 5% were on CreditWatch positive.

Slowing Economic Growth As Inflation Rears Its Ugly Head

Inflation has lasted longer than economists anticipated and has been more severe, with the U.S. Consumer Price Index (CPI) rising 8.5% over the past 12 months as of July 2022, now at a 40-year high. It also does not look different in other reinsurance markets such as the eurozone and the U.K., with expected CPI of 7.0% and 8.7% in 2022, respectively, and even Japan is expected to swing from its deflation in 2021 to 2.2% inflation in 2022. What was once considered a transitory phenomenon has showed persistence and caused rapid change in central banks' course of action. Most advanced economies are now moving more aggressively on interest rates than originally planned at the beginning of the year. The U.S. Federal Reserve officials, for example, raised their benchmark funds rate from near zero to 2.25%-2.50% as of July 2022, with more increases to come at the upcoming Federal Open Market Committee (FOMC) meetings.

Major economies are facing the threat of stagflation in the next 12-18 months resulting in slowing economic growth, which usually leads to lower demand for insurance. Reinsurers' top-line growth will be supported by expected hardening reinsurance rates. However, in real terms, the growth could be flat or even negative depending on lines of business. Inflation may also manifest itself into rising P/C re/insurance claims costs because of supply chain disruption, increased labor cost, shortage of parts, and higher body injury claims.

Over the past several years, the P/C re/insurance industry has been dealing with social inflation, especially in U.S. casualty lines, and now CPI inflation. Whether social or CPI, inflation risk is increasing for reinsurers as it elevates claims costs and potentially affects underwriting results from current and prior accident years, which could overshadow any benefits from higher investment yields. The impact of social inflation has already been visible in global reinsurers' reserve developments, which remained favorable, but the releases declined to about 1.5%-2.8% in 2019-2021 from about 4.7%-5.0% in 2017-2018. Because of social inflation coupled with our base-case assumptions on CPI inflation, we expect the benefit from reserve releases to further moderate to 1%-2% in 2022-2023. It seems that central banks are combatting inflation by aggressively raising interest rates and resuming quantitative tightening. S&P Global Ratings' economists expect inflation to moderate in 2023 and revert to normal levels in 2024. But this doesn't mean that inflation risk is abating given the whole host of uncertainties, including the Russia-Ukraine conflict impact on energy and commodity prices.

Table 1

Mark To Market Losses Battering Investments And Capital

The first half of 2022 has been painful for investors. According to Deutsche Bank, the 10% drop in the U.S. 10-year treasuries in the first half of 2022 was the steepest since 1788. Global equities have also tumbled, with the S&P 500 dropping 20.6% through June 30, 2022, which was its worst performance since 1962. On the bright side, rising interest rates will increase bond yields, thereby, boosting reinsurers' investment income, which will support earnings.

Overall, the top 21 reinsurers have well-diversified investment portfolios and are conservatively managed except for a few outliers. Over the past year or so, there was an increase in allocation to private equity and debt with the expectation of better returns relative to the public securities. In the first six months ended June 30, 2022, mark-to-market investment losses reduced reinsurers' shareholders' equity compared with year-end 2021. The drop varied among peers depending on their asset allocation and the duration of their bond portfolios. On average, the top 21 reinsurers' shareholders' equity dropped 13% relative to 10% for the Bermudians and 25% for the big four European reinsurers. The decline for the Europeans was more pronounced owing to their longer fixed income portfolio duration because of their life reinsurance and/or their primary insurance business.

Chart 1

Earning Cost Of Capital Remains An Obstacle

The industry has a poor track record when it comes to earning its cost of capital (COC, defined as the weighted average cost of capital). Reinsurers failed to surpass this hurdle in the past five years (2017-2021), except in 2019, and 2022 looks set to continue this trend. As central banks hike interest rates in sync to tame inflation, reinsurers' COC is also rising--making their job even harder.

In 2017 and 2018, the reinsurance sector generated returns on capital (ROCs) of only 3.2% and 2.0%, below its 7.4% and 7.9% COCs, respectively. Natural catastrophe losses, loss creep, and investment market volatility in fourth-quarter 2018 all played significant parts in these results. However, the improved investment returns in 2019 helped the sector earn in excess of its COC. This meant that the gap between the sector's actual ROC and COC was positive at 2.9 percentage points. In 2020, the sector took a major hit from COVID-19 and natural catastrophe losses, as well as significantly lower net investment income relative to the previous year. In 2021, ROC improved to 7.7% but still did not exceed the relatively higher COC of 9.1%. The trend will likely continue in 2022 because of financial market volatility. Although underwriting performance in P/C and life reinsurance is improving in our base case assumptions in 2022-2023, we believe the sector still needs to demonstrate its ability to sustainably earn its COC before we could potentially revise our view to stable from negative.

Chart 2

Reinsurers' Strategies Diverge On Natural Catastrophe Risk

According to Swiss Re Institute Sigma report, in 2021, the global economic losses due to natural catastrophes reached $270 billion, of which about 40% was covered by the re/insurance industry, highlighting a still very large protection gap. These natural disasters caused $111 billion of insured losses, which were the fourth highest since 1970. The main loss event in 2021 was Hurricane Ida in the U.S., which battered the south with category 4 force winds in August before tracking northeast, with an estimated insured losses of $30 billion to $32 billion. However, secondary perils such as severe convective storms, floods, and wildfires, accounted for 73% of all natural catastrophe losses in 2021 including Winter Storm Uri in the U.S. in February ($15 billion in insured losses), and multiple floods in central-western Europe in July ($13 billion in insured losses).

In the past five years, the global reinsurance sector generated a weak underwriting performance with an average combined ratio of 102.3%, hurt by elevated natural catastrophe losses, which added about 10 combined ratio points. Over this period, the frequency and severity of primary and secondary perils have increased, with the latter causing two-thirds of the increase. In addition, the magnitude of losses has been exacerbated by several factors including urbanization, higher asset values, underestimated exposures, supply chain disruption, increased material costs and labor shortage due to COVID-19, inflationary pressures, and the effects of climate change.

For the top 21 reinsurers we rate, we estimate that, on average, their capital is more exposed to natural catastrophe risk. Their net exposure as measured by a 1-in-250-year return period grew 4%, with average capital (shareholders' equity including preference shares) at risk increasing to 28% in January 2022 from 27% in January 2021. In addition, this cohort of reinsurers has markedly increased natural catastrophe budgets in 2022 compared with those in recent years, allowing for exposure growth.

However, when we take a closer look, there are two strategies at play. Half of the top 21 reinsurers are growing their natural catastrophe net exposure by close to 20% on average in 2022, while the other half is taking a more cautious and defensive stance by reducing their net exposure by an average of 20%. The divergence in strategies reflects reassessment of risk appetites, uneven pricing adequacy across the globe despite years of improved pricing, and loss fatigue. As we are still in the midst of the Atlantic hurricane season, which typically shapes the year's performance, outsize catastrophe events during the season could call into question the strategy of those reinsurers that have maintained or increased exposure to natural catastrophes.

Chart 3

Sector Anchored By Its Capital Strength

The global reinsurance sector entered 2022 with robust capitalization. In aggregate, the top 21 reinsurers' capital adequacy was redundant by 6% at the 'AA' confidence level in 2021, down from 7% in 2020. This cohort lost its capital redundancy at the 'AAA' confidence level in 2017 and hasn't recovered since then because of natural catastrophe and pandemic losses, adjustments to the large global reinsurers' asset-liability management and longevity risk capital charges, share buybacks, and special dividends.

Chart 4

We believe the capital adequacy buffer, currently at the 'AA' level, will erode in 2022 because of market volatility and the ensuing mark-to-market losses but will likely remain at the 'AA' level. Although most of these losses could be temporary, they may take a few years to unwind as bonds mature, depending on their duration. During that time, we would adjust our view of capital adequacy depending on changes in asset-liability mismatch and how quickly the maturing bonds are reinvested at higher yields. In addition, the increase in reserve discounting (and thereby a reduction in liabilities) and lower investment market values will help offset the impact from the unrealized losses on capital adequacy. Prospective strong underwriting earnings, along with increasing investment income, will also help offset this.

Table 2

The sector was affected by elevated natural catastrophes, COVID-19, and recently the ongoing Russia-Ukraine conflict. This cohort of companies reported $25 billion in pandemic losses from both P/C and life re/insurance in the past two and half years ($19.1 billion in 2020, $4.6 billion in 2021, and $1.3 billion in the first half of 2022). In addition, the top 21 reported $1.4 billion losses due to the Russia-Ukraine conflict in the first six months of 2022. We believe the situation is still fluid and further losses will be reported in the upcoming quarters.

Despite the lackluster underwriting performance in the past five years, the underlying metrics have improved in the past 18 months (2021 through first half of 2022) owing to favorable reinsurance pricing, with an average combined ratio of 96.5% in 2021 and low 90% area in the first half of 2022. In our base case, we forecast the combined ratio to improve to 95%-98% in 2022-2023, including a natural catastrophe load of about 8 percentage points to 10 percentage points. In 2022, we believe reported return on equity (ROE) will be affected by un/realized investment losses. However, in a more stable investment environment, ROE should improve to 7%-9% in 2023.

Chart 5

Reinsurance Pricing--A Game Of Cat And Mouse

Reinsurance renewals have become an increasingly dynamic process in recent years with unique factors affecting most lines of business. Property catastrophe reinsurance rates have been increasing since 2018, given the elevated catastrophe losses exacerbated by CPI inflation and supply chain issues. Casualty reinsurance lines have also seen compounded multiyear rate increases due to adverse loss trends in certain lines, rising loss-cost trends from social inflation, and, more recently, CPI inflation.

Reinsurers entered 2022 with such uncertainty, resulting in tighter capacity and continued rate increases across lines of business. The April renewals in Japan were orderly with modest rate improvements, reflecting reinsurers' subdued loss experience in that region in the past two years. However, come June and July, market conditions changed dramatically. Florida renewals saw significant reinsurance capacity contraction, tighter terms and conditions, and materially higher rate increases. The pricing in the casualty lines continued its momentum in 2022, but the pressure on ceding commissions have intensified and rates in certain lines have moderated.

While reinsurers are getting required price increases, rate adequacy particularly in property catastrophe is questionable, reflecting the divergence of strategies among reinsurers regarding this line of business. The pricing, which should be an indicator of prospective loss trends, seems to be an uphill struggle for the past several years. The growing impact of climate change, increasing losses from unmodeled secondary perils, higher inflationary pressure, and a litigious environment have resulted in accelerated loss trends, outpacing the property catastrophe reinsurance rate increases. Hence, reinsurers have tightened their property exposure management, creating a dislocation in this market.

Half of the top-21 reinsurers have reduced their property catastrophe exposure, with some exiting this line altogether. While reinsurance capacity is still available, the rising uncertainties have resulted in an increased demand for reinsurance from cedants. We believe this trend will persist and support rate increases into 2023. Aon PLC estimated more than $5 billion in additional reinsurance limits was sought by insurers at the June and July renewals, which was attributed to higher inflationary expectations.

In casualty reinsurance, we believe social and CPI inflation will keep loss reserves in check, further supporting rate increases into 2023. However, we believe rate increases will continue to moderate, particularly in lines of business where reinsurers have enjoyed multiyear rate increases.

The growing concern on the Russia-Ukraine conflict has altered the perception of risk in specialty lines. Particularly, aviation is a key focus area with potential large losses, which could result in sizable rate increases later this year and into 2023.

Alternative Capital Holds Firm Despite Flight To Quality Among Investors

Rising interest rates (thereby lower bond valuations) and volatility in the capital market have wiped out nearly $30 billion of traditional reinsurers' capital to $645 billion at the end of the first quarter of 2022, according to Aon. However, alternative capital, which includes collateralized reinsurance, catastrophe bonds, sidecars, and industry loss warranties, has held its ground, firmly reaching its previous all-time high of $97 billion from 2018. The growth is most prominent in catastrophe bonds, which had record issuances in 2020-2021, and 2022 is looking to be another record issuance year with $7.9 billion in issuances in the first half of 2022, according to Aon.

But all is not well in the alternative capital space. The investors in the recent past have been bruised by elevated losses and the resulting trapped capital, which has created doubts in their minds about the sponsors' (reinsurers) risk-modeling capabilities. As a result, there has been a flight to quality, with investors seeking to deploy capital with well-established and sophisticated risk managers.

Nonetheless, we believe the role of alternative capital in the global reinsurance marketplace has been growing. In an environment where reinsurers are tightly managing their severity exposures, we believe alternative capital could be more relevant than ever. In addition, given the increased loss experience in the property catastrophe lines, we believe alternative capital investors could look to explore the long-tail lines to manage their own volatility exposures. We believe the allure of alternative capital remains given it is less correlated to the traditional capital market trends. However, time will tell if alternative capital takes this opportunity to grow and widen its wings, while traditional capital struggles.

Chart 6

COVID-19 Brought Volatility, But Life Reinsurance's Fundamental Strengths Are Intact

In the past two and half years, the life reinsurance sector suffered from COVID-19 losses due to rising mortality rates in important markets such as the U.S., Europe, India, and South Africa. This underpins the importance of mortality business for the sector. As a result, the life reinsurance sector's ROE dropped to about 4% in 2020 and 2021 compared with the historical average (2015-2019) of about 10%.

We estimate that COVID-19 losses represented between 4% and 7% of life reinsurance's gross premiums written in 2020-2021. However, the sector remained profitable in these challenging years, benefitting from other sources of income including investment, and longevity and morbidity business. Virtually all the COVID-19 losses in the first half of 2022 emanated from life reinsurance business. The diversification benefit that life reinsurers enjoyed prior to the pandemic has significantly declined in the past couple of years. In 2022, we believe the sector will continue to perform below its historical level with an ROE of about 4%-6% considering pandemic losses in the first half of the year. However, in 2023 we assume further improvement in operating results back to historic norms with an ROE of 8%-10% based on our view of the sector's ability to adjust its pricing after the pandemic, rising interest rates, and a more moderate impact from COVID-19.

We continue to believe the fundamentals of life reinsurance remain intact and have not changed with the pandemic. The sector maintains high barriers to entry and is less price sensitive compared with P/C reinsurance, with significantly less market participants. Reinsurance buyers are sophisticated, precluding the need for intermediaries, and demand is driven less by available capacity and more by balance-sheet management. Demand has also been increasing by life insurers seeking capital relief.

The U.S. remains the sector's biggest market, with about 40% market share of global premiums with stable cession rates from primary insurers. The U.K. longevity business also continues to see strong demand. However, we believe the industry's future growth will come mostly 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 life reinsurance. Therefore, we think competition will remain largely stable over the next few years.

Chart 7

Looking Around The Corner

The reinsurance sector's performance over the past five years has been dismal. But during the past 18 months, underwriting results have improved as the industry continues to battle a host of issues, including elevated natural catastrophe exposure, pricing adequacy given the loss experience, high inflation risk, increasing cost of capital, and financial market volatility.

We believe fundamental, disciplined underwriting and adequate risk pricing, tighter terms and conditions with clear exclusions, and overall sophisticated risk management are key if reinsurers are to defend their competitive position and preserve earnings and capital strength. On the bright side, reinsurance pricing is improving with the expectation that it will carry on into 2023 renewals, and new underwriting opportunities could be the lifebuoy needed for the sector to regain its footing and begin to earn its cost of capital once again.

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Related Research

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• S&P Global Ratings Top 40 Global Reinsurers And Reinsurers By Country: 2022, Aug. 30, 2022
• Global Reinsurers Part Ways On Natural Catastrophe Risk--Even As Prices Rise, Aug. 29, 2022
• Cyber Risk In A New Era: The Future For Insurance-Linked Securities In The Cyber Market Looks Uncertain, Aug. 24, 2022
• Credit FAQ: How Will The Move To IFRS 17 Affect S&P Global Ratings' Analysis Of Insurers And Reinsurers?, Aug. 24, 2022
• Lloyd's Market 2022 Review: Let The Good Times Roll?, Aug. 24, 2022
• Russia-Ukraine Conflict Adds To A Bumpy Start To 2022 For Global Reinsurers, March 31, 2022