Increased volatility and ratings pressure push up reinsurance demand: Aon

Reinsurance demand increased in the first half of 2020 and is expected to tick up again at 1.1 as insurers face a heightened view of risk and volatility and rating agency pressures, at the same time as new entrants seek support from reinsurers, according to broker Aon.

In its latest Reinsurance Market Outlook report, the firm also noted that global reinsurer capital had fallen by 2 percent over the first six months of the year, despite a rebound in the financial markets in Q2 and $8.0bn of new equity issuance.

Despite capital raising, Aon said it expects capacity to continue tightening at 1 January.

During the last six months, Aon said some global insurers were able to effectively increase their property catastrophe risk transfer to help offset the potential further impact of Covid-19 losses. The broker also noted that insurers were able to renew capacity for peak zone exposures in what it described as “a relatively orderly fashion during the spring”.

And Aon predicted that, should these dynamics remain, then the expectation is there will be a slight increase in demand from insurers for property catastrophe coverage during the January 2021 renewals.

As the broker explained, losses from Covid-19 and its associated impact on the investment markets and the global economy have highlighted how interrelated risks can be, especially under stress events.

When combined with mounting concerns about the impact of climate change, Aon said it sees risk managers “evolving their view of ‘tail risk’ scenarios”.

“In general, these are resulting in a view of increased frequency of high severity, stress scenario events. As such, we have seen increased demand to mitigate tail risk from catastrophe events as well as from potential loss development on legacy reserves via adverse development covers,” Aon said.

Earnings protection

Earnings protections are also increasingly coming to the fore as a series of “mini-cats” from secondary perils impact underwriting results.

More broadly than just catastrophe risk, Aon said industry reserve dynamics and recent rate increases may also suggest potential increased demand.

“The increasing rate environment and new entrants in the market will feed demand for reinsurance.”

Aon’s Reinsurance Market Outlook, September 2020

That will, however, be balanced with the need to meet positive risk transfer metrics for insurers who can retain the risk if those metrics fall out of line, Aon noted.

Ratings agency pressure will also drive reinsurance demand. The Covid-19 outbreak prompted rating agencies to change various sector outlooks to negative.

Fitch Ratings dropped its industry outlook to negative, while S&P, AM Best and Fitch revised their views on the US Commercial sector to negative.

With commercial insurance and reinsurance rates on the rise, there has been significant capital inflow into the sector and that too will drive demand, Aon said.

“We estimate that approximately $8bn has been raised since March to support insurance capital, with around 80 percent focused on offensive/growth strategies.

“In addition, there are several new company formations in the works that will push the total capital raise above $10bn. The increasing rate environment and new entrants in the market will feed demand for reinsurance,” the broker stated in its report.

The growth of fronting companies are also providing another source of reinsurance demand.

With captives set to grow in prominence given changes in primary market terms and conditions, as well as reduced capacity for certain lines of business, reinsurers may also see demand increase from this specialist segment of the market.

Rated captives, Aon explained, have used reinsurance to manage rating agency tail risk scenarios. The increased utilisation of captives will in turn lead to heightened reinsurance demand.

Captive risk managers and sponsor-entity CFOs for unrated captives are re-evaluating capital requirements, including increased use of reinsurance, to afford greater flexibility to the insurance vehicle’s ultimate parent, Aon said.

Capacity to continue tightening at 1 January

Those cedants that can articulate the impacts of Covid-19 on their portfolio from losses and also changing primary market trends at a time when capacity is tightening will “undoubtedly” be best positioned for the 2021 renewals, Aon said.

At the beginning of the year, Aon forecast that there would be “a modest tightening” of reinsurance capacity during 2020. Reinsurers, Aon explained, had entered 2020 with a need to improve earnings, but they faced various headwinds including declining interest rates, reserving risk from social inflation and deteriorations on major losses as well as increasing retrocession costs.

The coronavirus outbreak has only served to exacerbate many of those pressures, Aon said.

Negative impacts on both sides of the industry’s balance sheet will “likely result” in the reinsurance industry failing to cover its cost of capital in 2020, according to Aon.

With interest rates having been cut in response to the pandemic, Aon said “considerable uncertainty remains around the ultimate extent and distribution of related claims and additional collateral will be trapped as a result”.

The tightening of capacity that was evident at the midyear renewals “will likely remain in play at January 1”, Aon said, although it will be mitigated slightly by the influx of new capital that has materialised.

But certain downsize risks must also be considered, in particular the potential for further major natural catastrophe losses and/or Covid-19 related capital market volatility between now and year end.

Q2 reinsurance capital increases

Looking more broadly at the industry, Aon said global reinsurance capital increased during the second quarter and recovered some of the ground lost during the first three months of 2020. Come the end of 2020’s Q2, global reinsurance capital stood at $610bn, up from the $590bn following the conclusion of this year’s first quarter, but still down on the $625bn at year end 2019.

Combined with the new issuances, traditional reinsurance equity capital is now $519bn. As Aon explained, this rebound from the drop in the first quarter was aided by $8bn of new issuance during Q2.

“The total is little changed relative to the end of 2016, partly reflecting the impact of natural catastrophe losses in the intervening period,” the broker said.

“Risk-based capital adequacy has declined as a result, but solvency ratios generally remain comfortable across the reinsurance sector,” it added.

And even though the alternative capital market remains impacted by trapped capital from historical losses, investors continue to be drawn to the sector owing to the diversification benefits afforded by reinsurance risk.

According to Aon, alternative capital accounted for approximately 15 percent of global reinsurance capital come the end of 2020’s second quarter, equal to $91bn. However, that $91bn still reflects a reduction of 4 percent when compared with year end 2019.

“Some of the assets supporting collateralized reinsurance contracts have been trapped, due to the ongoing uncertainty surrounding the ultimate extent of recent major losses, now including Covid-19,” said Aon.

“As a result, the funds available for deployment are somewhat lower than the headline total would suggest, a phenomenon which is impacting the retrocessional market in particular,” it noted.