Reinsurance Valuation Trends

Competitive Landscape

The US reinsurance industry remains somewhat concentrated with the two largest industry participants, General Re (a division of Berkshire Hathaway) and Reinsurance Group of America, Inc., commanding a combined market share of 44 percent (an increase from 33 percent in 2016). General Re increased market share from approximately 25 percent to 36 percent over the last 2 years while Reinsurance Group of America, Inc., remained flat at approximately 8 percent of market share over the same time period. While there are 165 reinsurers in the marketplace, the industry's concentration is expected to continue to grow as insurers seek consolidation to increase capital levels to meet higher demand from primary insurance markets. ²

Portfolio Management

Reinsurance companies pay close attention to market conditions as they position their portfolio exposures to particular risks. Generally, premiums are affected by changes in policy counts and pricing, which fluctuate between hard and soft cycles. During hard-pricing cycles, prices rise as insurers try to build reserves and maximize underwriting profits. In contrast, soft cycles occur when prices fall, as reinsurers competitively price policies in an attempt to gain market share. The change between these two cycles depends highly on catastrophic activity and investment returns, as unusual spikes in claims and decreases in investment income curtail reserves and profitability.

Due to 2017's catastrophe losses, reinsurers have increased their appetite for proportional business and are expected to benefit from higher rates on primary insurance. ³ Additionally, during the period from 2017 to 2018, the industry's combined ratio declined from 106.6 to 99.7, and alternative capital experienced gains year over year. ⁴ Furthermore, the industry has shown resiliency in the first quarter of 2019 as the industry limited losses to approximately $7 billion, which is 47 percent below the 15‑year average of first-quarter losses of $13.5 billion for the period 2004 through 2018. ⁵ However, optimism from positive trends might be curtailed by robust competition in 2019.

Capital Exposure

As a result of the losses observed in 2018, global reinsurer capital, a measure of the capital available for insurers to trade risk with, declined 3 percent during 2018 to $585 billion. ⁶ Within total capital, traditional capital declined by 5 percent in 2018, stemming from higher interest rates that drove unrealized losses in bond portfolios, the strengthening dollar, and the fourth quarter stock market decline. ⁷ Conversely, alternative capital grew by $8 billion and represented approximately 16.5 percent of total capital in 2018. ⁸

Many investors have been paying keen attention to the role that alternative capital in the form of insurance‑linked securities (ILS) has played and will continue to play in the reinsurance business. ILS are comprised of a range of financial instruments, most notably catastrophe bonds, which are issued in order to provide insurance or reinsurance protection to insurers, reinsurers, governments, and corporations. ILS issuances allow investors to be exposed to the unique risk and return profile of reinsurance, which is attractive due to its independence from financial market returns. By selling policies bundled as ILS, reinsurers are able to access a more diversified capital pool and reduce credit risk relative to bearing all liability for insured losses themselves. ⁹ However, this alternative capital also poses a different type of risk to reinsurers in that ILS investors such as pensions, endowments, and other large institutional players have long-term costs of capital (target returns) that tend to be lower than reinsurers weighted average cost of capital. This allows these institutional investors to profitably assume risks at prices that would create losses for traditional reinsurance providers.

Returns on Capital

A concern raised during 2018 is that the industry's soft cycle persisted through 2018 with returns for many reinsurers calculated to be below their cost of capital. S&P Global Ratings expects the sector's return on capital to increase to 6–8 percent in 2018, which is near the average reinsurer's cost of capital of 7–8 percent. ¹⁰

Factors in play included the ballooning number of catastrophic events during 2017 and 2018 and potential loss creep, which is identified as a prolonged period of loss evolution caused by situations such as claims litigation and delayed claims filings by third-party contractors that may impact profits. ¹¹ As 2019 progresses, renewals may give an indication of the impact that loss creep has had on reinsurance pricing levels. ¹²

Furthermore, the rising cost of capital and diminishing return profiles from investments might limit earnings growth in the near term.

Market Approach to Valuation

Premiums and or discounts to book value are one of the commonly used metrics for evaluating a reinsurer's effectiveness at generating returns by measuring whether the returns are above or below its cost of capital. In the below analysis, I present the price to tangible book value (P/TBV) multiples. While there may be exceptions, for most reinsurers, value is driven by growth, risk, and profitability.

Growth

Companies with greater sustainable long-term growth prospects tend to be more valuable than those with less growth potential. However, growth must be considered within the context of risk. For example, a reinsurer may exhibit slower growth than its peers due to more conservative underwriting policies, which would normally result in lower risk. As a result, in determining an appropriate valuation multiple, the analyst should weigh the value of the reinsurer's more conservative risk profile against the negative impact of its lower growth prospects.

Risk

One primary risk factor for reinsurers is the risk of underwritten policies. While higher risk policies tend to have a negative impact on value, they can also provide higher premium growth. Because of the volatile nature of the industry and unpredictability of catastrophic loss events, industry operators periodically update facultative underwriting policies to balance underwritten risk in accordance with changing industry and market conditions. Thus, policy risk and growth potential need to be considered together in order to assess value.

Profitability

In the reinsurance industry, profitability is generally driven by whether there is a soft or hard market and the occurrence (or lack) of catastrophic events, such as hurricanes for property and casualty reinsurers, that result in large losses. The specific impact on a given reinsurer depends on many factors, such as the following.

• The individual insurer's exposure to the product line in which the insurance event occurred
• The magnitude of the insurance event
• The type of the reinsurance contract (proportional or nonproportional/excess of loss) that the reinsurer has underwritten

In addition to claims-related expenses, profitability is affected by policy acquisition/underwriting costs, overhead costs, and investment income.

Current Valuation Trends

Historically, industry participants have faced extremely volatile profit margins due to the uncertainty surrounding pricing premiums to cover unpredictable catastrophic losses and fluctuating claims. We note that return on equity has declined since levels seen in 2014 as rising expense ratios have put downward pressure on profitability. ¹³ As shown in Figure 1, current market valuations (measured using P/TBV) for the industry group generally tracked with the industry group's return on equity for years 2014 through 2018.

Figure 1: P/TBV and Average Return on EquiData obtained from S&P Capital IQ as of April 30, 2019.

As shown in Figure 2, ¹⁴ current market valuations (measured using P/TBV) for the industry group ranged from a low of 0.6 times to a high of 1.9 times, with an average of 1.1 times with differences in each company's multiple being attributed to varying levels of exposure to catastrophic risk along with company-specific factors such as growth strategy, product-line exposure, portfolio risk, and profitability. As noted previously, due to the contraction in the spread between the reinsurance industry's cost of capital and expected returns over the last several years, both P/TBV multiple and return on equity have been on a downward trend.

Figure 2: P/TBV

Insights can also be drawn from observing historical ratios and trends for the Industry Group. Figure 3 ¹⁵ presents monthly data from January of 2013 to April of 2019.

Figure 3: Average P/TBV Trend Line

Since January 2013, the industry group has traded at 1.1 times tangible book value, which is represented by the horizontal line in the graph shown above. The two dotted lines represent industry multiples that are +/- 2 standard deviations away from the historical average and represent expected upper and lower bounds for industry multiples as this range contains approximately 95 percent of observations. Albeit an oversimplification, net tangible book value can be a rough proxy as a lower bound on a reinsurance company's valuation of the equity in a liquidation scenario. The average P/TBV of the industry group would be expected to generally trend toward (at least) 1.0 times as this would imply that the underlying companies were worth the amount of capital they carried on their books.

The trend line on the graph demonstrates that the industry group's average annual P/TBV tends to be mean reverting. The industry average multiple crossed the upper band in December 2013, hitting a high of 1.19 times following a lack of catastrophic loss events and continued overall improvement in the market following the end of the recession but reverted back to the historical average multiple over the subsequent 6-month period. In December 2018, the industry group multiple crossed the lower band, dropping to a P/TBV of 0.94 times as reinsurers experienced low returns on ILS and loss creep from 2017 offset increasing interest rates and the corresponding expected growth from investment income. However, valuation multiples increased through the first quarter of 2019, settling slightly above the historical average as equity markets recovered from a decline in the fourth quarter of 2018; interest rates continued to rise, and volatility declined.

Outlook for 2019

The industry is expected to benefit from continued capacity growth and rising interest rates as industry participants generate more investment income. ¹⁶ Additionally, climate change issues present an opportunity for the reinsurance industry as the frequency of weather-related catastrophes increases and presents more opportunities to tap into demand growth from traditional insurers related to risk adaptation strategies associated with climate change. ¹⁷ Since ceding insurers typically obtain reinsurance for high-risk policies, reinsurance operators generally underwrite high-risk classes of insurance.

Demand for reinsurance usually expands following catastrophic disasters, during which time reinsurers will enjoy a hard market, increasing prices to offset underwriting losses. ¹⁸ However, following losses after major catastrophic events in 2017, the industry has not yet entered into a traditional hard cycle. Therefore, for companies to remain profitable, lower premiums and increased frequency of and/or severity of catastrophic loss events must be offset by higher investment returns and enhanced underwriting discipline. ¹⁹ Nevertheless, a challenging business environment lies ahead for reinsurers as a soft pricing market and alternative capital providers put pressure on margins and the costs of capital continue to rise.