Some of the confusion results from the unpredictability of the duration and ultimate severity of the crisis, along with the magnitude and length of the resultant recession.
The challenge of calling the market also reflects the emergence of countervailing dynamics. A reduced gap between supply and demand – along with a shock loss and a volatile investment environment, combined with an expectation of reduced interest rates long term – should drive rate increases.
However, this collides headlong with the reduced ability of cedants to pay owing to “less money in the system”, and the significant reduction in exposures due to reduced activity in most areas of society and the economy. We are labelling this the "should pay, can't pay" problem.
The picture is further complicated by the bandwidth being consumed by political lobbying around BI cover and fights within the industry around exclusionary wording. The scope for reputational risk and damage to relationships is another key factor at play.
We believe the base case is an acceleration of rate momentum in reinsurance, although with a drop-off in premium levels in the short term. It should also be stressed that there is a high degree of uncertainty amidst a chaotic competitive landscape.
The importance of the behaviour of key groups of actors could also still decisively shape the outcome. Others may follow where industry leaders first go.
The approach taken by Guy Carpenter and Aon will matter, including the extent to which they urge clients to privilege continuity of cover or cost-conscious purchasing.
Similarly, the approach of the major reinsurers – above all the continental big four, as well as Berkshire Hathaway if it stirs from sleep – will play its part.
Where will the emphasis be placed as they balance the trade-offs between pushing exclusions and securing rate?
Who will see the turmoil as a chance to claim market share and who will retrench and de-risk?
There are broadly three schools of thought on the path forward in reinsurance:
These divergent views do not map neatly onto traditional divides like broker vs carrier or cedant vs reinsurer, with some brokers among the most bullish on rates and reinsurers among the most reticent to forecast rate rises.
The case for Surge
Reinsurance pricing showed modest and uneven uplift through 1 January and 1 April, as cat pricing advanced only very modestly outside of stressed areas and casualty gains were still largely driven by improved original pricing.
However, reinsurance sentiment has been more buoyant over the past four months than previously, with widespread predictions that reinsurance rates would move more materially mid-year following meaningful advances in primary rates.
The underlying causes of the modest transition have been a prolonged period of soft market pricing, leading into an elevated period of cat losses ($220bn in two years), followed by mounting loss emergence across a range of casualty lines driven by the tort environment. Other contributing factors include an increased cost of capital from double-digit increase in retrocession costs in 2019 and 2020, and the effective removal of cheap pillared cover from the market.
Reinsurance shows signs of behaving like a commodity market, particularly in cat, and those bullish on pricing stress that after a significant period of supply-demand imbalance, the two are set to converge as disruption takes hold.
Reinsurers will suffer an asset-side shock resulting from the equities market crash and turmoil in the bonds market, although the picture is evolving rapidly and government action to shore up economic confidence as well as slowing death rates in some countries has led to some recovery in the past 14 days.
Sources have talked about an expectation of mid-single-digit to high single-digit book value erosion, equivalent to a mild capital event.
If the non-damage BI exclusions are not overturned by lawmakers, most in the industry expect a "manageable" underwriting loss across the sector. Nevertheless, the systemic nature of the disruption will make the event a multi-class clash loss, with claims set to seep into a wide range of classes. Market sources have suggested that upwards of 15 Lloyd's risk codes are projected to take losses.
The contingency market will take crushing losses. Real punishment is also in store for trade credit (re)insurers. Other hotspots are expected to include care homes, healthcare and directors’ and officers’ (D&O).
There is still scope for substantial property losses to emerge as a result of BI claims in instances where wording is weak, or in the isolated markets where pandemic cover was included for a large swathe of clients. Losses from all these lines will flow through to the reinsurance market.
Reinsurers have repeatedly stressed parallels with 9/11 given that this is another multi-class, "shock loss" that was not fully priced for in the models.
There is likely to be clear downward pressure on available reinsurance capacity, as book value depletion combines with a risk-off mentality among reinsurers wary of further macroeconomic volatility.
Alongside this, reinsurers looking to manage PMLs to a percentage of at-risk capital may feel the need to reduce their net cat bet.
Given the present state of the retro market and the challenge in finding new limit, retrenchment on the front end looks more likely.
ILS squeeze
Current ILS market dynamics will both pressure the availability of capacity in first-tier reinsurance markets where the collateralised markets play, and via retro.
Some private predictions that the ILS market would melt down have proved wildly inaccurate to date.
However, broking sources are talking about high single-digit redemptions from many ILS funds, much of it owing to the automatic rebalancing of multi-strategy investment portfolios following the equities crash. The flow of new money in the near term is also highly likely to dry up.
If the key question for ILS coming into 2020 was when it would be able to weather the crisis of 2018/19 to return to growth, the answer now looks to be – not yet. As such, it seems like 2020 will be another year in which ILS will play a reduced role, something which points to additional upward rate pressure in Florida (circa 15 percent market share) and retro (circa 60 percent).
Reinsurers will also be operating in an environment of heightened ratings agency and regulatory scrutiny.
The first signs of this have already emerged, with Fitch moving to place Lloyd's on negative watch in an advisory which cited its lack of 2019 progress, but which also explicitly referenced the pending impact of Covid-19. AM Best has also indicated it will carry out a stress test of insurers to evaluate the impact of coronavirus on capital levels, investment portfolios and loss reserves.
Regulators have also been dialling up their interest in the sector, with Eiopa urging restraint on active capital management and executive compensation. The PRA has also urged UK insurers to be “prudent” in the distribution of profits to shareholder, while French regulator ACPR has imposed a dividend freeze.
Meanwhile, it seems likely that cedants will look to buy additional reinsurance owing to the same combination of reduced book value, mid-crisis conservatism and PML management.
Broking sources have suggested they are receiving the first queries about placing additional cover, with structured quota shares and top-ups on cat XoLs among expected structures.
Reinsurers are also highly cognisant of the likelihood that the world is heading for a "lower for longer" scenario on interest rates. Increased spreads will act as a short-term offset, but the collapse of government bond yields will be an earnings headwind over time, with the impact on casualty lines acute.
The case for Fail
Although many of the conditions in place would typically drive market hardening – potentially rapid hardening – they could be neutralised by the brutal reality of recession, with a range of senior sources subscribing to this view.
Goldman Sachs has downgraded its forecast for the US economy again and now expects GDP to contract by 34 percent in the second quarter.
As GDP collapses many insureds will suffer precipitous falls in revenue. This will create cashflow pressure and a spike in insolvencies, taking clients out while rendering some unable to pay and others far less able to pay.
Market bears fix on this reduction in the amount of money in the system as the spoiler at a time when risk-transfer "should" become more expensive.
This is what we are calling the "should pay, can't pay" problem, and it will be acutely felt in some industry verticals, and to a lesser extent in the negotiations between cedants and reinsurers.
The collapse of economic activity in certain areas will also “break” some lines of business, putting downward pressure on premium levels – although the read-across to rates will not be straightforward.
The reduction in premium levels will extend to lines of business reliant on project-based income, and to lines serving challenged industries.
These will include aviation, energy (largely owing to the oil price), marine, construction, surety, structured trade credit and transactional liability.
However, it will also include areas like trade credit insurance in Continental Europe where governments look like they will distort markets post-loss by stepping in to provide cover.
The handbrake effect on rates is less clear but dynamics will also be shaped by the collapse in exposures.
Sister title Inside P&C described the Covid-19 as an effective “get-out-of-jail-free" card on frequency for the US P&C industry. And the same thing will be true everywhere, with less activity across all aspects of lives slashing exposures and suppressing losses.
Reinsurers are already seeing the first evidence of brokers seeking to negotiate premium rebates on deals where exposures have collapsed, and others will seek to recoup some money back when they are short of the minimum deposit premium level (typically 80 percent) at the end of the renewal.
The approach mid-term is likely to vary heavily depending on the past performance of the account and perceived quality of the client. The same dynamics are likely to characterise renewal discussions across many lines of business, and we could see more funds-withheld quota shares agreed or other structures to reflect the uncertainty.
Altogether, there will be pressure for reinsurers to accept less premium, potentially setting up exposure-adjusted rate as the real flashpoint, as struggles shift towards calculating exposure cuts, and potential restructures including co-insurances and increased retentions.
The case for Lag
Some market sources believe that the real push to drive reinsurance rates higher will not come in the mid-year renewals, with a lag effect likely to be in operation.
This is projected for a number of reasons, but the biggest is the primacy of the exclusion fight.
The pre-eminent concern of reinsurers at this point is ensuring that they limit future exposure to Covid-19 losses by securing watertight exclusions in cat treaties.
Partially this is about preventing additional exposure to soft property wordings which will let through pandemic losses, but primarily it reflects an attempt to end-stop exposure to the doomsday scenario in which governments retrospectively overturn clear exclusions on BI cover.
The US is probably ground zero for this fight over the bankruptcy of the sector, but the likely torturous passage of the dispute through the courts – as well as its insufficient capitalisation – almost certainly rules the industry out as a backdoor bailout fund for the US economy.
Sources have said that state lawmakers have already started asking for data from insurers about their reinsurance programmes, flagging the scope for reinsurers to be drawn into the fight.
The industry's focus at the highest levels – at least in the US – right now is directed towards averting a crisis as a wave of uncovered BI claims have to be rejected while insurers come under fire. As such, the early fights over wording could encourage reinsurers to deploy whatever leverage they have here rather than to secure major rate rises.
Japan's 1 April renewals already provide something of a test case for this thesis, with reinsurers ultimately accepting 35-55 percent increases on wind layers that were on a par with the pre-existing path. Instead of pushing for deals to reprice as the turmoil grew, they redirected their efforts to securing exclusions for Covid-19 exposures.
The second key plank of the "lag" case is that reputational risk will constrain behaviour, curbing rate rises.
Much of the franchise value of reinsurers rests on the relationships they have built up with their clients over many years, and at a time of acute stress they will have to balance the need to drive a near-term improvement in returns with protecting that goodwill.
Reinsurers will need to walk a difficult line here, and deferring rate rises until the economy rebounds would be one way to do that.
Third, the reinsurance industry has a history of delayed rate responses, with significant rises after prior shocks including KRW needing more than six months to play out.
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