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Captive-Trends 2018

Captive Insurance Issues and Trends 2018

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Where Things Stand—Insurance, Reinsurance, and Alternative Capital

Businessman at Precipice-SF
March 07, 2018

On March 1, 2018, Kroll Bond Rating Agency (KBRA) released its report titled U.S. Property/Casualty Industry 2018 Outlook. As we approach the end of the first quarter of 2018, it seems apropos to take a look at the state of the market as respects primary insurance, reinsurance, and alternative capital. While captive insurers make up a portion of the overall market, they are buffeted by the same forces as all of the other players. Understanding some of the dynamics can allow management and boards to make midcourse corrections, if necessary, or confirm that current operational plans are sound.

Primary Insurance

KBRA reported as follows.

Despite the magnitude of catastrophe losses faced in 2017 and below-average operating return metrics, KBRA believes the U.S. P/C sector is financially sound. At the end of 2017 capital will be at a record high, aided by high-quality investment portfolios and strong total returns. Our key takeaways from 2017 include:

  • industry resiliency—and risk transfer discipline—despite an out of the ordinary Atlantic hurricane season;
  • price stabilization occurring across both personal and commercial lines;
  • signs pointing to a change in the reserve position across many U.S. [insurers]—with a potential deficiency in the next couple of years; and
  • insurance company insolvencies remaining below the historical average.

Let's look at each of these bullet points in relation to the captive insurance market.

Estimates for natural catastrophe losses for 2017 range from $105 billion to $135 billion, making the past year one of the worst on record. However, global insurance industry capital and surplus hit a record of $719.4 billion at September 30, 2017. Even given the erosion that occurred in the fourth quarter, industry capital escaped fairly unscathed. As KBRA notes, this indicates there is still considerable resiliency in the industry. The same is probably true for the majority of captive insurers. The abundance of capacity in the reinsurance markets has allowed captives to easily transfer risk off their balance sheets.  Most captive insurers, assuming they had underwritten their book of business properly and practiced risk discipline as noted in the report, saw no material impact to their capital positions.

The captive industry, like their cousins in the primary property and casualty (P&C) markets, has been waiting for abatement of soft market pricing conditions. For captives, this has been a delicate dance, trying to maintain some pricing discipline while also forestalling member defections to the primary markets as rates fell. As catastrophe (CAT) losses mounted in 2017, many industry insiders and observers anticipated market pricing would finally turn and pricing power would return.

The KBRA paper references an analysis provided by Dowling Hales, insurance merger and acquisition specialists, in the Hales Report, concerning the pricing outlook for 2018. The salient quote is as follows.

While an inflection point has seemingly been reached, and with added resolve from [insurers] following 2017 catastrophe activity, it remains to be seen how significant the firming market will be in 2018, both in magnitude and duration.

For now, on the heels of a significant CAT year, several major writers are clearly looking to "test" the market's receptiveness to rate increases. With near record retention rates for large commercial insurers, there will likely be at least some near-term success.

While this suggests a respite from the downward pressures on rates, it clearly is not a significant hardening of the market. Therefore, captive insurers are likely to face continued pricing pressures and competition for their best risks from the traditional P&C insurers.

One potential bright spot for captives is the decline in reserve redundancies among the primary insurers. Operating results over the last several years have been bolstered by insurers being able to reduce reserves and release dollars back into earnings. Given projected underwriting losses in 2017 and prior years' releases, KBRA is forecasting reserve positions are likely to move to a deficient position in the next couple of years. This should bring the need for increased pricing, allowing captives to piggyback on the upward move in rates—assuming they can sustain themselves until then.

Reinsurance

As CAT losses mounted during the third and fourth quarters of 2017, expectations grew for significant pricing increases in the reinsurance markets. However, as 2017 became 2018, hope for a substantial increase in pricing power faded with reports that the January 1 renewal rates were underwhelming. In "Jan 1st reinsurance renewal pricing more a ceiling than a floor: KBW," a February 19, 2018, roundup report, Artemis, a Bermuda-based news and data media service, stated the following.

Analysts at Keefe, Bruyette & Woods explained in a recent report, "We think the combination of reasonably prevalent releases of 3Q17 catastrophe loss reserves (mostly for reinsurance) and sustained alternative capital inflows make January 1 reinsurance renewals more of a ceiling than a floor."

If reinsurance pricing reached a ceiling at January 1st then there is only one direction for it to move from here, while market forces continue to ramp up the amount of capital seeking a relatively static amount of underwriting business.

The question for the mid-year renewals should perhaps be one of how sticky the ceiling may be, rather than one of further price rises.

For captives, this is relatively good news. It suggests access to reinsurance capacity should remain fairly abundant, allowing captives to transfer as much risk, at reasonable prices, as they deem prudent. This will act as a buffer against primary insurer pricing pressures discussed above.

Alternative Capital

No discussion of the insurance markets is complete without looking at alternative capital, also known as the insurance-linked securities (ILS) market. While there are many ILS reports available these days, we tend to favor the analysis provided by Swiss Re. The following is a summary drawn from the Swiss Re Insurance-Linked Securities Market Update—January 2018

What an incredible year 2017 was! It was unprecedented for the Insurance-Linked Securities (ILS) market in a number of ways. Many records were set in new issuance by the midway point of the year. Meanwhile, the summer and fall brought significant stress to the market with a number of large catastrophic events....

The unrelenting barrage of catastrophic events in the second half led to increased volatility and large bond price swings, especially on bonds with aggregate triggers. The anticipated losses arising from these events served to halt the years' long spread-tightening trend that seemed to have no floor. Some had forecast a capitulation of alternative capital and a return to pricing of five years prior. However, the investor community was largely able to shore up its capital base and displayed a readiness to reinvest in upcoming transactions, albeit at improved terms....

In our view, 2017 provided the first real test of the resiliency of the ILS market. Up until this past year, investor losses in individual bonds had been almost nonexistent, resulting in a downward trend in pricing/required yield. Market observers, ourselves included, had wondered what would happen when investors were forced to take a principal haircut. As Swiss Re notes, while there was increased price volatility in the market, investors as a whole rode out the storm (no pun intended) and have continued to embrace alternative capital.

For captive insurers, this is relatively good news. Most captives today do not make use of the alternative capital markets, primarily because of their size. We think, though, after having seen the market go through its first real upheaval, there is likely to be increased interest in creating pooled ILS deals for smaller entities such as captives. Management teams and boards would be well advised to explore these alternatives. While traditional reinsurance pricing remains attractive, there is nothing wrong with adding more sources of risk transfer to your portfolio in anticipation of a change in market conditions.

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