Reinsurers meet cost of capital for first time since 2019

Reinsurers meet cost of capital for first time since 2019 | Insurance Business Australia

Reinsurance

Reinsurers meet cost of capital for first time since 2019

Sound risk management and burgeoning partnership with alternative capital were key drivers

Reinsurance

By
Kenneth Araullo

Reinsurers managed to meet or exceed their cost of capital in 2023 for the first time in four years, thanks to sound risk management, strategic use of technology, and a growing partnership with alternative capital, according to a report from AM Best.

These factors have helped stabilize the traditionally cyclical reinsurance market by reducing the extremes. To maintain or surpass the cost of capital, reinsurers must balance short-term market opportunities with long-term strategic goals, ensuring they remain relevant and dependable over time.

In recent years, rising interest rates, stock market volatility, weather events, and inflation have increased the cost of both debt and equity. The reinsurance industry’s weighted average cost of capital (WACC) had declined from 9.5% in 2010 to 6.25% in 2019, before rising to 9.31% in 2021

After a decline in 2022, it increased again to 8.12% in 2023. Despite these challenges, reinsurers in 2023 generated returns well above the cost of capital, supported by positive underwriting results driven by the repricing and de-risking of reinsurance portfolios.

The current hard market emerged due to prolonged underperformance, economic and social inflation, and the impact of a prolonged low-interest-rate environment, despite a relative abundance of capital. Rate increases have begun to slow—Guy Carpenter reported a 5.4% increase in Rate-On-Line (ROL) for US and European property catastrophe reinsurers at Jan. 1, 2024, compared to nearly 30% in 2023.

However, reinsurers have also implemented stringent de-risking measures, such as tightening terms and conditions and significantly increasing attachment points. These measures are unlikely to be relaxed soon and have contributed to more sustainable pricing, enhancing reinsurers’ ability to meet their cost of capital over the medium term.

Meeting the cost of capital remains challenging for reinsurers that take on high-severity risks, particularly during years with severe catastrophe losses. The relationship between the median return on capital employed (ROCE) and the median WACC highlights this challenge.

WACC measures a company’s cost of both debt and equity, while ROCE assesses how well a company generates profits from its capital. Significant volatility in returns can indicate inefficiencies in managing risk, leading to a higher cost of capital.

There are various methods to estimate the cost of equity, AM Best explains, with the Capital Asset Pricing Model (CAPM) being the most widely used. CAPM divides risk into systematic risk, which is market-related and measured by beta, and unsystematic risk, which is specific to a company and can be diversified. The cost of debt is simpler to calculate, typically by averaging the yield to maturity of a company’s outstanding debt.

Over the past 12 years, the spread between ROCE and WACC has fluctuated. In 2011, global insurance losses reached approximately $150 billion due to a severe tornado season in the United States, earthquakes in New Zealand and Japan, and floods in Thailand.

Despite such events, the reinsurance industry’s ROCE remained relatively steady between 2011 and 2016, even in the face of Superstorm Sandy in 2012.

Reinsurers strive to optimize their cost of capital and maximize returns while aligning with their risk appetites. Significant volatility in returns can indicate inefficiencies in risk management, leading to a higher cost of capital. An insurer’s ability to raise capital, especially during times of stress, and the associated cost of capital are crucial considerations in the ratings process.

In assessing operating performance, comparisons are made between an insurer’s return on equity, its peers, and its cost of capital, as well as other metrics such as return on revenue, combined ratio, return on assets, and underwriting expenses. The absolute level of these metrics and their historical volatility are also examined.

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