Citi analysts, led by Todd Bault, postulate that reinsurers under-reserved and underpriced risk during the late 1990s resulting in more volatility and lower returns in the early 2000s. The financial crisis of 2008 prompted reinsurers to recapitalize and currently reserves seem adequate. However, return on equity has suffered and has not recovered to late 1990s levels.

Todd Bault and his team believe that reinsurers need to prove that they can go through a crisis like the one presented in 2008 without having to raise substantial capital. They also affirm that in hindsight capital levels that were acceptable in the 1990s were unrealistically low. Furthermore, reinsurers also need to reduce their assumed risk.

Reinsurance

Reinsurance ROE reinsurers

Reinsurers underpriced relative to primary insurers

Todd Bault thinks that there has been a negative pricing spread between reinsurers and primary insurers since 2001-2003. Now it seems that the majority of reinsurance is underpriced versus its primary source business. In Bault’s view, the underpricing could be driven by primary insurers exercising adverse selection against reinsurers by keeping favorable risk exposures and passing on risks with higher loss ratios to reinsurers. The chart below shows that the spread between gross (total risks) and ceded (passed to reinsurers) exposures has been rising steadily during the 2000s. If Bault’s adverse selection thesis is correct, it implies that the available pool of reinsurance suffered a steady quality decline making an already competitive industry more challenging. Investors need to be even more selective when it comes to reinsurance investments focusing on companies’ underwriting philosophies and skill levels.

Bault’s analysis focuses on worker’s compensation, general liability, professional indemnity, and commercial auto liability sectors. The goal is to approximate non-catastrophic losses by choosing sectors that are less sensitive to them given that catastrophic losses cannot be explicitly removed from available data. Additionally, property reinsurers are the most widely followed by market participants.

Non-cat commercial Accident

Citi’s analysis attempts to determine whether price changes are keeping pace with losses. The spread between prices and losses is defined as the effective price change. If prices go up faster than losses paid out, then loss ratios decline showing an improving trend. The chart below seems to indicate that loss ratios are better for both primary insurers and reinsurers.

Effective price changes

However, Citi remains worried about price adequacy, which they defined as insurers’ capacity to produce favorable loss ratios given current pricing. In the chart below, price adequacy above 0% implies that insurers can cover forecasted losses and minimize loss ratios. During the 1990s, the chart suggests that reinsurance had higher price adequacy than primary insurance. In the 2000s, the difference reverses and primary insurers have more favorable loss exposures than reinsurers and the price adequacy spread is higher. The increasing spread likely supports Bault’s adverse selection argument.

Price adequacy levels

Reinsurer stocks unattractive

Todd Bault and his team conclude that lower returns on equity together with adverse selection on ceded reinsurance business reduce stock gain potential on reinsurers. The latter may be growing their books at the expense of quality resulting in higher loss ratios and lower profits.

Citi analysts rate Axis Capital Holdings Limited (NYSE:AXS) and XL Group plc (NYSE:XL) sell despite both stocks having low price to book ratios and presenting potential for a turnaround. RenaissanceRe Holdings Ltd. (NYSE:RNR) is rated neutral as it is regarded as one of the most sophisticated reinsurers globally. However, RenaissanceRe’s exposure to declining prices (15% decline according to reinsurance broker Guy Carpenter) in the property catastrophic loss sector neutralize the company’s ability to generate superior returns on its risk exposures.