AM Best: Reinsurers meet cost of capital following repricing and de-risking corrections

Reinsurers met their cost of capital in 2023 for the first time in four years, driven by a rebound in capital gains and underwriting profits as a result of repricing and portfolio de-risking, according to a new report by AM Best.

The rating agency calculated that the reinsurance industry’s median weighted average cost of capital (WACC) rose to 8.12 percent in 2023.

Between 2011 and 2021, the largest median posted stood at 9.31 percent in 2021, then falling to 7.35 percent in 2022.

The increased cost of capital has been driven by a combination of high interest rates, equity market volatility, and economic uncertainty, which offset a relative abundance of capital.

“To meet or go above the cost of capital, reinsurers must remain flexible with regard to market conditions and balance opportunistic moves (taking advantage of market conditions, retreating when pricing is not right) over the short term, with strategic long-term goals,” said AM Best.

“Rate increases are slowing down, but reinsurers have also implemented thorough de-risking measures such as tightening T&Cs and sharply increasing attachment points, which are unlikely to be relaxed. The hardened market has led to more sustainable pricing momentum, enhancing reinsurers’ ability to meet their cost of capital over the medium term.”

The report added that for reinsurers taking on high severity risks, meeting their cost of capital during years of severe cat losses presents a challenge. AM Best highlighted that this is particularly evident when comparing the median return on capital employed and the median WACC.

Years in which returns exceed the cost of capital are generally those with a lower nat cat frequency and severity. Despite the higher median WACC, reinsurers met the cost of capital in 2023, as well as the median ROE compared to the cost of equity.

The majority of reinsurance players saw an “excellent” ROE in 2023, with a median of 16.41 percent – the highest in 12 years by a margin of 3.7 percentage points.

“These returns are due to ongoing positive underwriting results, as well as recoupment of unrealised investment losses from previous years thanks to higher reinvestment rates,” AM Best explained.

“The exceptional ROE in 2023 is unlikely to be repeated, although reinsurers are expected to maintain underwriting discipline over the near term.”

The report concluded that the dispersion of returns reflect differences in risk management. Generally, in years where losses were more severe, the variance in the spread of returns was wider – for example, in 2022 (a year with high cat losses), returns ranged from -15 percent to 16 percent.

However, 2023 was an exception, with the wider spread (3 percent to 26 percent) owing to a few exceptional returns.

“Reinsurers in the third quartile experienced more volatility in these cases, due to the lack of effective risk management and exposures to risk outside investors’ risk appetite,” said the report.

“In contrast, reinsurers in the first quartile tend to rely on effective risk management, appropriate portfolio concentration, and diversification. They are more likely to see a narrower spread of returns, often meeting or exceeding the cost of capital.”