JLT Re VIEWPOINT REINSURANCE: THE PRICE IS RIGHT

Transcription

1 JLT Re VIEWPOINT REINSURANCE: THE PRICE IS RIGHT

2 CONTENTS SECTION 1: RIDING THE REINSURANCE CYCLE... 4 SECTION 2: THE PARADOX OF REINSURANCE CAPITAL... 9 SECTION 3: COUNTERACTING THE CYCLE SECTION 4: CONCLUSION JLT Re Viewpoint is JLT Re s regular series of reports that comment on or give insight into key topics, occurrences or changes in the (re)insurance and broking marketplace. At JLT Re, our trusted team combines market leading expertise and proprietary analytical tools with the freedom to challenge conventions. We create new insights and explore innovative capital solutions tailored to meet client needs. TOGETHER, WE DELIVER RESULTS

3 3 EXECUTIVE SUMMARY The reinsurance sector has experienced a period of unexpected profitability and capital growth since the record insured catastrophe loss year of The anticipated high frequency of natural catastrophes has not materialised. Concerns around reserving adequacy and capital uncertainty have also proved to be unfounded as the last five years have been dominated by net reserve releases and a significant influx of third-party capital. These factors, combined with unrealised gains, have topped-up an already abundant capital base, leading inevitably to a supply glut. This increase in reinsurance capacity came at a time of lowering demand as cedents consolidated purchasing. The result has been four years of falling reinsurance rates across most lines of business. There has been a capitulation of sorts on the part of some reinsurers who insisted two or three years ago that rates were too low, technically unprofitable or simply not worth writing. Nevertheless, confronted with intense competition amidst a sustained soft market, the rhetoric of previous years was soon forgotten as underwriters sought to protect market share. Speculation about new normal market conditions gathered pace, into which third-party capital would flow perpetually on a linear, if not exponential, trajectory and where the best hope for a reinsurance carrier was to be acquired by some nebulous deus ex macchina for 200% of book value. Today, this is the prevailing view that the reinsurance sector has changed structurally and even, in some quarters, that the cycle is dead. But the reinsurance sector has been through periods of rapid structural change before and has nevertheless remained cyclical. One very significant change happened in the late 1980s and early 1990s with the establishment of Bermuda as a hub for small and medium-sized reinsurance start-ups. Over USD 13 billion (roughly 20 billion in current USD) 1 entered the sector via new listings during this time. Despite incumbents initial scepticism, Bermuda went on to become an established and crucial part of the market. Indeed, Bermuda itself has now traded through at least two reinsurance cycles. This report examines the reasons why the sector has arrived at its current state and sets forth several different scenarios in which the market could change rapidly in the near to medium-term. It is the opinion of JLT Re that the reinsurance sector, although clearly changed from that of 10 years ago, remains cyclical and that discerning clients can use the cycle to their advantage. Furthermore, there are clear signs in place that the reinsurance market as we have known it for the last four years is about to undergo further change. There is opportunity now for carriers to seize the moment and utilise highly competitive reinsurance as a capital optimisation tool. Indeed, analysis carried out by JLT Re shows that reinsurance, at current pricing levels, is increasingly a more efficient form of contingent capital than debt, equity and carriers own capital. Reinsurance of course has a cost but analysis shows that this cost is currently lower than other forms of capital. By deploying reinsurance strategically, cedents can increase franchise value, support new growth initiatives and pursue more profitable business in order to navigate successfully today s challenging operating environment. 1 Source: JLT Re, Bloomberg data.

4 4 SECTION 1: RIDING THE REINSURANCE CYCLE The reinsurance sector is notoriously cyclical, with fluctuations in capacity and price par for the course. Not only are soft markets commonplace, soft or softening phases characterise the state-ofthe-market for the majority of the time. As one industry veteran said a few years ago, only one in six years of his career could be characterised by a truly hard market. This may have stretched to one in seven since he said so. Still, the underlying forces behind the current soft market are unique as they are linked to a coalescence of macroeconomic forces following the financial crisis, combined with traditional and non-traditional market dynamics. CALM BEFORE THE (NEXT) STORM Any market outsider reviewing Figure1 would be forgiven for concluding that the cost of property-catastrophe protection should be rising. There is some logic to this view. Although global property-catastrophe reinsurance pricing has fallen 30% in the last three years due in part to below-average loss activity, the potential for insured catastrophe losses has risen at an exponential rate since the 1970s. Comparing the most expensive insured catastrophe loss year of the 1970s of USD 16 billion in 1979 to this decade s high of USD 133 billion in suggests a compound annual growth rate of approximately 6% in terms of the largest loss experiences, implying the very real possibility of a USD 200 billion loss year before the decade is out. Figure 1: Inflation-Adjusted Insured Catastrophe Losses 1970 to 2015 USD billion Seismic Meteorological Man-made Next time? year moving average Number of events (RHS) (Source: JLT Re, Swiss Re) 2 Both loss figures adjusted to 2016 USD.

5 5 Figure 2: Simple Average Cession Rate of Top 20 Global P&C Carriers 1998 to % 14% 12% 10% 8% 6% COUNTERINTUITIVE BUYING BEHAVIOURS Cedents purchasing behaviours, over the last 15 years at least, have not reflected this presumption of higher expected loss experience. Figure 2 shows the simple average of cession rates (premium ceded divided by premiums written and assumed) of the top 20 global property and casualty (P&C) carriers from The chart clearly shows that the insurance sector is at a long-term cyclical low in terms of reinsurance purchase. 4% SUPPLY GLUT USD billion Traditional Alternative Catastrophe bonds Collateralised / sidecars Industry loss warranties (Source: JLT Re, Bloomberg data) Figure 3: Dedicated Reinsurance Sector Capital and Gross Written Premiums 1998 to Q Q Gross premiums Falling demand has coincided with a markedly increased supply of dedicated reinsurance capital over the last decade. This has been driven by three key factors: higher asset values, net calendar year reserve releases since , and, crucially, the entry of tens of billions of dollars of alternative capital into the sector. This new, asset manager and pension fund-provided capital began to enter the sector more rapidly in 2011 as yields on certain insurance-linked securities reached as high as 12% with expected losses as low as 3%. In the wake of the global financial crisis, as well as various sovereign debt crises, a BB rated security with a low correlation to other asset classes yielding 12% with an expected loss of 3% was considered to be a very attractive proposition by investors. The result was a structural change in how capital is provided to the reinsurance

6 6 Figure 4: Average Rate Movements by Line of Business at 1 January 2016 Average risk-adjusted rate change (loss-free) -20% -15% -10% -5% 0% 5% 10% US Property-Cat Western Europe Property-Cat Asia Pacific Property-Cat London Market Global Property Retrocession Property-Cat Industry Loss Warranties US Public Entity Middle East P&C US Workers Compensation London Market Casualty Western Europe Motor Western Europe GTPL Cyber Aviation Marine & Energy (Asia Pacific) Terrorism Agriculture (Asia Pacific) Accident & Health Catastrophe North America Med Mal Australia Med Mal Medical Professional Liability Figure 5: JLT Re s Florida Property-Catastrophe Rate-on-Line Index 1992 to

7 7 market and in how much capital can enter and exit the sector. Figure 3 (on page 5) shows dedicated reinsurance capital compared to gross reinsurance premiums written going back to It is striking that the sector, which has historically traded at a solvency margin ratio (capital divided by premiums) of about 80%, today trades closer to 125%, the inverse of historical norms. PRICING CORRECTION The predictable result of all of this is not only lower property-catastrophe reinsurance pricing, but lower rates generally across most business lines. Figures 4 and 5 show loss-free riskadjusted rate movements across several lines at 1 January 2016 and risk-adjusted property-catastrophe rate changes since Virtually all lines of business saw rate reductions at 1 January 2016 whilst risk-adjusted property-catastrophe reinsurance rates-on-line (ROLs) have fallen to such an extent over the last five years that they were approaching the previous cyclical low of 2000 at mid-year 2016.

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9 9 SECTION 2: THE PARADOX OF REINSURANCE CAPITAL WHY ARE CESSIONS SO LOW? Given reinsurance pricing has experienced double-digit declines across most lines of business in recent years, it does seem paradoxical that buyers have simultaneously been retaining more risk. Part of the reason is simply the increasing inelasticity of demand. This has in turn been influenced by at least five factors: Primary insurance carriers are themselves struggling to grow, especially in developed markets, due to lacklustre economic growth and resultant primary pricing pressure in most lines of business. This creates an incentive to retain more premium. Primary carriers asset portfolios have grown significantly. This has been due to a flight to quality assets in the years since the financial crisis in short and medium-duration bonds. Insurance carriers, as opposed to banks or mutual funds, are now the largest holders of high grade corporate fixed income securities 3. On the short end of the curve, insurance carriers assets have been bolstered by stimulative government fiscal policies. The result of all of this, on paper, is a higher level of reported capital particularly under IFRS and US GAAP precluding the perceived need for reinsurance capital in certain business lines. The growing influence of capital models has enabled carriers to demonstrate the benefits of risk diversification, in theory at least. Some cedents have used this information to reassess their purchasing strategies and buy less reinsurance. From 2011 onwards, many insurance carriers began aggressively consolidating the purchase of reinsurance from regional hubs with local expertise to group headquarters in the hope of gaining economic efficiencies and better pricing. Relatively low loss experiences during this time accelerated this trend. Finally, cedent mergers and acquisitions (M&A) have, in certain cases, proved to be a catalyst for further reinsurance buying consolidation. 3 Source: JLT Re, Bloomberg data.

10 10 All these dynamics, in addition to the increased supply of reinsurance capital, have driven reinsurance pricing to levels not seen since the late 1990s. Whilst acknowledging that price is only one of several factors to consider, it is now becoming the received wisdom that lower rates are a symptom of a structural market change. Third-party capital providers can enter the property-catastrophe market rapidly, goes the argument, thereby dampening the prospect of any post-event market hardening. THE RECEIVED WISDOM: IS IT CORRECT? Despite the challenging operating environment, it can be convincingly argued that there is yet hope for the reinsurance sector, and that at least part of what is being experienced is cyclical, not structural. Already, there are early indications of a cyclical shift to come before the decade is out. If these indications turn into trends, the stage will be set for a true change in market sentiment. It must be remembered that it was not simply Hurricane Katrina which led to a hard market in Rather, it was an accumulation of factors over several years beginning with the dot-com bust which was then followed by the 9/11 attacks, a long-tail reserving crisis (which forced several carriers to recapitalise) and a succession of devastating landfalling hurricanes in the United States (including Charley, Frances, Ivan, Jeanne, Katrina, Rita and Wilma). What does this mean today? It suggests even a repeat of some of the larger losses the sector has experienced since 1970 would be unlikely to dent the current overabundance of capital and there must be an accompanying backdrop of cyclical and macroeconomic trends to create a sustained market turn. At present there are at least three indications of emerging trends which, if continued, could create this backdrop. Figure 6: P&C Accident Year Reserving Trends 1987 to % 130% 125% 120% 115% 110% 105% 100% Percentage of property-catastrophe limit 95% 90% 85% 80% 75% 70% 60% 50% 40% 30% 20% 10% All lines Short tail property Redundancies Deficiencies US workers comp Recent trend % Other market estimates: ca. 40% by 2020* UK general liability Figure 7: Projections of Alternative Capacity As A Percentage of Total Property- Catastrophe Limit JLT Re s-curve estimate: 25% - 30% in the 2020s *Some market participants have estimated that third-party capital could make up approximately 40% of global property-catastrophe limit by 2020.

11 11 Indication 1: A moderation of reserve redundancies and increasing instances of deficiencies Arguably the largest catastrophes ever to befall the risk transfer business have not been the mega property-related events which feature prominently in the headlines, but the slow build-up of reserve weakness driven by aggressive pricing in longer-tail, non-catastrophe lines over extended periods of time. Periods of reserve deficiencies have typically had more bearing on the pricing environment due to a prevailing lack of trust in counterparty balance sheets and general boardroom uncertainty. In the late 1990s, cash flow underwriting briefly became a catchphrase which described aggressive underwriting to gain market share with the hope that realised gains on investments and investment income would make up the difference. This paved the way for the liability crisis which hit almost all multiline P&C carriers on a calendar-year basis beginning in the early 2000s. Carriers subsequently became increasingly in some cases irrationally conservative with loss picks (estimations of ultimate losses for the underwriting year in question) which has meant that since the 2006 accounting year, reserves have been generally redundant. This has enabled insurers and reinsurers to release large amounts of these redundancies into earnings as it has become increasingly evident that loss picks for the post-liability crisis accident years were indeed too high. Something is now changing. Figure 6 shows the development of reserves by accident year. Whilst the most recent accident years have admittedly not had time to develop sufficiently to make broad conclusions, the trend is nevertheless clear. Where accident years 2003 through to 2007 were, in aggregate, redundant in longer-tailed business lines, experience since accident year 2008 has been more varied. Carriers are now likely to have released most of the redundant reserves they built up between 2003 and 2007 and there is therefore growing concern releases may start to dry up. This seems to have been borne out in the fourth quarter of 2015 in particular as several carriers reported net deficiencies in key business lines. At a minimum, this means it can now no longer be assumed that reserves will always prove to be a reliable source of earnings. Indeed, the sector may see net accident year deficiencies for some of the more recent, less developed accident years. Indication 2: A more disciplined rate of thirdparty capital entry Up until the middle of 2015, it was widely accepted that alternative capital would continue to flow into the reinsurance sector unabated. Estimates of third-party capital equalling up to 40% of property-catastrophe limit by 2020 were common. Whilst JLT Re certainly believes that alternative capital will continue to grow as a percentage of total outstanding limit, we anticipate that the rate of growth is likely to be less than these estimates. It can be observed, for example, that 2015 was not a record catastrophe bond issuance year in fact, JLT Re data shows issuance was USD 1 billion lower than in Furthermore, third-party capital as a percentage of property-catastrophe limit stands at roughly 19%, which represents an important but still marginal increase on previous years. This increased maturity and discipline is indicative of stable institutional money that has made a long-term commitment to the market. So whilst third-party capital is now undoubtedly a permanent feature of the reinsurance market, particularly in the property-catastrophe segment, its entry into the sector can no-longer be described as exponential or even straightline. As yields on catastrophe bonds stabilise at around 5% or 6% with uncorrelated expected losses of around 3%, it is likely that the entry of alternative capital into the sector will resemble an s-curve, as shown by the blue line in Figure 7. Indication 3: Interest rate risk Closely related to more disciplined capital inflows is interest rate risk. As the largest holders of medium-duration, highgrade fixed income securities, insurers are particularly vulnerable to sudden and rapid movements in interest rates. Whilst asset-liability-matched insurer bond portfolios are designed to withstand interest rate shocks, yields currently stand at 60-year lows and are even negative for certain government securities. This creates inherent instability in the bond market 4 and with increased rating agency and regulatory risk charges for nearly every other asset class, the insurance sector is especially susceptible to rising interest rates. Although a steepening of the yield curve may be manageable for most, a rapid shift, accompanied by expensive catastrophe losses or increases in loss cost inflation, could 4 Bill Gross, Janus Capital, 9 June 2016.

12 12 create, at a minimum, inter-divisional or general liquidity problems for certain carriers. As an illustration, Figure 8 shows the impact on a USD 20 billion, 3-year duration liability position backed by a matched A rated bond portfolio in the event of a rapid 1.2 percentage point increase in inflation expectations. As claims costs begin to rise and the value of the bond portfolio declines by USD 1.5 billion due to an increase of 1.4 percentage points in the three-year yield, the total combined effect is a USD 3 billion balance sheet shortfall. Figure 8: Vulnerability of Balance Sheets to Interest Rate Risk 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% Balance sheet Technical Bond reserves portfolio $21.5bn $18.5bn Equity shortfall of $3bn 1.4 p.p. yield curve shift at 3-yr maturity Of course, the counter-argument to this is that rising loss cost inflation would be partially offset by an increase in the discount rate for medium and longertail reserves. Higher inflation would also likely result in higher pricing, which could compensate for worsening loss picks. Nevertheless, the fixed income securities market has more potential to create stress on insurers balance sheets than at any time since the early 1980s. RETHINKING REINSURANCE STRATEGIES All three indicators highlighted here are capable of creating conditions for an eventual market turn. Although this may not materialise immediately or even in the relatively near-term, the potential clearly exists. These risks, combined with the fact that reinsurance pricing is currently at historically low levels, create sufficient reason for insurance carriers to re-examine reinsurance as a form of contingent capital. The bottom of the pricing cycle represents the optimal time to buy 0.5% 0% 3M 6M 1Y 2Y reinsurance, and with rates for certain business lines showing early signs of nearing a floor, current market conditions offer cedents attractive buying opportunities. As Figure 5 on page 6 shows, declines in risk-adjusted property-catastrophe ROLs moderated considerably at mid-year 2016, reaffirming a trend of gradual price stabilisation that first emerged during the corresponding period in Rates nearing technical minimums (i.e. the point where returns on capital fall below costs of capital) was fundamental in bringing about these signs of stabilisation. Price deterioration likewise contributed to the wave of M&A activity in 2014 and 2015 as reinsurers sought to improve diversification and build scale. It also helps explain why the top 15 reinsurers by market capitalisation now trade, on average, just above their book value at 1.1x, even after three years of belowaverage losses. 3Y 5Y 7Y A GOLDEN OPPORTUNITY 10Y Reinsurance therefore offers an extremely efficient form of capital at today s pricing levels. Given the current market environment, now is the time for insurance carriers to consider how their firm s weighted average cost of capital (WACC) compares to the cost of reinsurance capital for the line of business in question. An example of JLT Re s cost of capital analysis is shown in Figure 9, comparing the top 15 global P&C insurers WACC with the cost of property-catastrophe reinsurance over the last decade 5. The chart reveals that a significant gap between these two forms of capital emerged in 2013 and has grown substantially in subsequent years. In fact, our analysis shows that the cost of property-catastrophe reinsurance today is approximately 35% cheaper than the WACC of the top 15 global P&C carriers.

13 13 This implies that insurers could be better positioned to satisfy shareholders demands, rating agency and regulatory requirements and (in theory) increase valuations by swapping debt and equity for less expensive reinsurance. Cedents should therefore carefully re-examine strategic reinsurance purchases, not only as regards of earnings protection but also for value creation, and consider utilising today s competitivelypriced reinsurance to support growth goals. There is early evidence that this is already happening as cedents increasingly consider new quota share programmes, aggregate covers, excess-of-loss buy-downs and adverse development covers (ADCs). Indeed, JLT Re observed carriers increasingly returning to the reinsurance market outside of the major renewal cycles in the first half of 2016 to top-up cover and take advantage of the price arbitrage shown below. At the margin, then, there is finally an increase in demand, however inelastic, as reinsurance is seen as an exceptionally competitive form of contingent capital at current pricing levels. Figure 9: Top 15 Global P&C Insurers WACC Versus Cost of Property-Catastrophe Reinsurance 2006 to % 11% 10% 9% 8% 7% 6% 5% 4% WACC Cost of property-catastrophe reinsurance capital 5 It should be noted that the cost of property-catastrophe reinsurance shown in Figure 9 is not the ROL, but premiums ceded (less commissions) divided by expected recoveries.

14 14 SECTION 3: COUNTERACTING THE CYCLE Carriers with the foresight to exploit today s cost effective reinsurance can help secure future profitability by preparing for the next unforeseen event(s) which could precipitate or accompany a turn in the market. Such scenarios do not require a series of Black Swan events to unfold. History points to several natural catastrophe disasters that would be capable of seriously denting the sector s current excess capital position. In a 2012 study, Karen Clark & Company (KCC) identified a number of historical US hurricane events that could cause insured losses of USD 50 billion or more if they were to reoccur today. The most expensive event would be the Great Miami hurricane of 1926, with a projected loss of USD 125 billion. In a separate study, KCC demonstrated how claims from several potential 100-year hurricane characteristic events (CE) are capable of leading to outsized and solvency-impairing losses along the US coastline 6. For example, a category 5 hurricane making landfall near Galveston in Texas would likely result in a loss of more than USD 100 billion. A similar event in Miami could see losses exceed USD 200 billion. Earthquakes are also capable of causing significant losses to the global (re)insurance sector. For example, a reoccurrence of the 1811/12 earthquake clusters in the New Madrid seismic zone in the United States could trigger an insured loss of between USD 110 billion and USD 150 billion today, according to AIR Worldwide and Swiss Re, respectively. As detailed previously, risks are not only confined to the forces of Mother Nature. Man-made losses remain a constant threat, underreserving has been the main cause of financial impairment in the (re)insurance sector whilst inflation and interest rate risks have the potential to negatively impact balances sheets (an issue that is particularly pertinent today as the Federal Reserve looks to establish a more normalised interest rate environment). 6 In KCC s CE approach, hazard probabilities are quantified and losses are then estimated for different return period events. It is therefore the flip side of the exceedance probability (EP) curve approach i.e. the probabilities are based on the hazard versus the loss.

15 15 GPW USD 7 billion Specialty Property 20% 45% Casualty 35% 1.0x 0.8x 0.6x 0.4x 0.2x 0.0x Company A Company A Company B Solvency margin ratio Cession rate* GPW USD 7 billion Cession rate** 5% 12% Property 45% 12% * Cedes 5% of premium, mainly excess of loss catastrophe cover. ** Cedes 12% of premium to buy a global aggregate cover, a 10% quota share for its workers compensation business and an ADC for developed long and medium-tailed lines. 9% 6% 3% 0% Figure 10: Price to Book Ratios Versus Forward Earnings Price to Book 2.5x 2.0x 1.5x 1.0x 0.5x 0.0x Company B Specialty 20% Casualty 35% Company A Company B Forward RoE 0% 2% 4% 6% 8% 10% 12% 14% Forward RoE Company A Company B DISASTER SCENARIOS The myriad of threats that characterise today s risk landscape have the potential to alter the sector s operating environment. To illustrate the point, JLT Re has created two hypothetical companies (see infographic opposite) and four disaster scenarios to show how major natural catastrophe losses, large manmade disasters, sudden macroeconomic changes and adverse reserve development issues, or a combination of all four, could impact balance sheets. Although the fallout from all four scenarios is different, reinsurance offers an effective and efficient form of capital to protect balance sheets from each circumstance. Before presenting the different scenarios, it is interesting to note that hypothetical price to book ratios for these two companies can be derived were they to trade alongside peer companies in today s market. Figure 10 shows roughly where Company A and Company B would sit on the valuation scale. Figure 10 shows a clear correlation between forward earnings and franchise value. It is nevertheless notable that Company A trades only slightly higher at 1.26x book value compared to 1.18x for Company B. This is because Company B, even though it has lower earnings expectations, has a more efficient capital structure with less volatile expected future earnings. As the following scenarios show, this has an outsized effect on franchise value in the event of non-attritional losses.

16 16 SCENARIO 1: A USD 100 billion catastrophe loss emanating from a category 5 hurricane making landfall in Galveston, Texas. The outcome is strikingly different for both companies and clearly demonstrates the value of reinsurance as contingent capital. Given Company A has retained more risk and purchased less reinsurance, it suffers a net loss of USD 1.74 billion. Company B, meanwhile, benefits from its more comprehensive reinsurance programme as its loss comes to just USD 500 million. This translates into a realised return on equity (RoE) of -24.4% for Company A but only -0.8% for Company B (see Figure 11). SCENARIO 2: A USD 200 billion catastrophe loss emanating from a category 5 hurricane making landfall in Miami, Florida. In this scenario, Company A suffers a massive USD 2.5 billion loss. Company B s more comprehensive reinsurance programme limits its net loss to just USD 1 billion (60% less than Company A). This equates to an RoE of -39.6% for Company A and -10.8% for Company B (see Figure 12). Figure 11: Return on Equity Projections for Scenario 1 20% 10% 0% -10% -20% -30% -40% -50% -60% 20% Company A Opening ERoE Company A Company B Realised RoE Figure 12: Return on Equity Projections for Scenario 2 Company B SCENARIO 3: A USD 100 billion catastrophe loss emanating from a category 5 hurricane making landfall in Galveston, Texas, coupled with the US government attempting to renegotiate debt repayments resulting in a two percentage point upward shift in the A+ yield curve, and a fall in the US dollar resulting in a two percentage point increase in US inflation. Figure 13 shows this scenario is devastating for Company A, which suffers a 47.1% negative RoE due to a combination of hurricane losses, 10% 0% -10% -20% -30% -40% -50% -60% Opening ERoE Realised RoE

17 17 higher than expected loss cost inflation (resulting in deficient reserves) and realised losses on the bond portfolio (only marginally offset by higher yields on new investments). SCENARIO 4: All components of Scenario 3 plus a large petrochemical plant explosion amounting to a total industry loss of USD 5 billion, of which Company A and Company B has a 10% share. Figure 14 shows that Company A loses over half of its capital base with a negative RoE of -55.6% in this scenario. A capital loss of this size has in the past typically resulted in most carriers being placed immediately into run-off, either as the result of a series of rating downgrades or from statutory administration. Company B, by contrast, suffers a negative RoE of -21.7% a poor result, but not catastrophic. In this scenario, Company A would most likely be out of business whilst Company B would be in a position to re-load and take advantage of the inevitable market hardening. It would be too speculative to try to estimate precisely the market capitalisation change for both firms in these scenarios. Nevertheless, it is safe to assume that Company B s value would be significantly higher than Company A s in all four circumstances. It would also benefit from relative financial strength rating protection. All this is achieved by utilising a more comprehensive reinsurance structure, which cost about one percentage point on the RoE an expense which is significantly lower than the marginal cost of most other forms of capital. Figure 13: Return on Equity Projections for Scenario 3 20% 10% 0% -10% -20% -30% -40% -50% -60% 20% 10% 0% -10% -20% -30% -40% -50% -60% Company A Opening ERoE Company A Opening ERoE Company B Realised RoE Figure 14: Return on Equity Projections for Scenario 4 Company B Realised RoE

18 18 SECTION 4: CONCLUSION The peaks and troughs of the underwriting cycle have long been core features of the reinsurance market. No two cycles are the same and market developments over the last five years have seemingly transformed the sector s capital structure, potentially influencing the duration and volatility of future cycles. But the cycle is not dead. The reinsurance market will not stand still forever and there are already emerging trends around reserving, capital inflows and the macroeconomic environment that could prove to be catalysts for future change. The key conclusions from this report underscore the value and efficiency of reinsurance capital in the current marketplace. Double-digit rate declines across most lines of business in recent years mean that reinsurance is now potentially the best-priced source of capital for most carriers. JLT Re s cost of capital analysis shows that, at current pricing levels, reinsurance is typically the most cost effective form of capital when measured against debt, equity and cedents own capital. The value of reinsurance protection is further demonstrated by the four different disaster scenarios outlined in this report. Each scenario, whether it be a major loss, a sudden macroeconomic shock or reserving risk (or a combination of all three), shows how increased reinsurance spend can minimise volatility and protect cedents balance sheets in the event of market changing losses. The competitivelypriced reinsurance capacity on offer today therefore presents cedents with a significant opportunity to lower their costs of capital, increase franchise value, grow profitably and, ultimately, position themselves for future success. Reinsurance buyers can secure competitive advantages by anticipating cyclical change and JLT Re is committed to deliver its best-in-class advice and risk transfer products to support clients in managing market change. By investing in research capabilities and drawing on the vast array of expertise within the firm, JLT Re is uniquely placed to inform the discussion around rapidly evolving market dynamics and thereby create the most effective and innovative solutions for our clients.

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20 20 CONTACTS David Flandro Global Head of Analytics London +44 (0) Keith Harrison Chief Executive Officer UK & Europe London +44 (0) Julian Alovisi Head of Research and Publications London +44 (0) Ed Hochberg Chief Executive Officer North America Philadelphia Isabella Gaster Head of Communications and Marketing +44 (0) Stuart Beatty Chief Executive Officer Asia Pacific Singapore stuart.beatty@jltre.com UK & Europe North America Asia Pacific Middle East Africa This publication is for the benefit of clients and prospective clients of JLT Re. It is intended only to highlight general issues that may be of interest in relation to the subject matter and does not necessarily deal with every important topic nor cover every aspect of the topics with which it deals. The information and opinions contained in this publication may change without notice at any time. If you intend to take any action or make any decision on the basis of the content of this publication, you should first seek specific professional advice and verify its content. JLT Re is a trading name and logo of various JLT reinsurance broking entities and divisions globally and any services provided to clients by JLT Re may be through one or more of JLT s regulated businesses _07.16