Bermuda’s reinsurers are operating in an increasingly competitive market with margins likely to be squeezed further by a combination of growing competition from third-party capital and decreasing demand for reinsurance.

That is the picture painted by analysts from rating agency AM Best, who nevertheless see the market as strong and characterised by sensible pricing of risk.

In a report set to be published today, entitled “Stuck in the Middle: Reinsurers face converging capital, rising retentions”, AM Best examines industry trends in the US and Bermuda market.

Among its conclusions are that the growth of capital market involvement in the industry would likely continue and that reinsurers would need to innovate to underwrite new lines of business beyond the heavily-modelled and data-rich risks that have proved most attractive to third-party capital.

On the capital management side, the report finds that Bermuda reinsurers spent fully half of their net income earned so far this year on buying back their own shares — a trend encouraged by the lack of catastrophes that has limited claims payouts this year.

AM Best states that the US and Bermuda market’s strength goes beyond the oft-quoted generality that it is overcapitalised. “However, this market’s strength goes much deeper,” the report states. “It is true that risk-adjusted capital is strong, but the focus on prudent underwriting and pricing fundamentals has led to this achievement. Executive management teams have held the line, expecting to be paid adequately for the risks they take.”

The fact that US and Bermuda reinsurers write a relatively more concentrated amount of US catastrophe business left them most exposed to the most competitive area of the market, Best said.

“Potentially seismic shifts are taking place below the surface in the (re)insurance industry, and the US and Bermuda market companies are near the epicentre,” the report states.

Capital from yield-hungry, third-party investors such as hedge funds and pension funds continues to “flood the industry”, taking higher-layer risks, while insurers (the buyers of reinsurance) are increasing the amount of risk they retain, leaving reinsurers “stuck in the middle”, AM Best notes. However, the rating agency adds: “This is not to suggest that capital convergence in the (re)insurance industry is an immediate death knell for the traditional model.”

The report continues: “This external capital is vast and becoming more comfortable with (re)insurance risks. It is very likely to continue to increase its presence in some manner.”

Two of the big unknowns with this capital convergence are how much capital the industry will continue to attract and its level of long-term commitment.

Best noted that pricing of reinsurance contract renewals in June and July — the key period for catastrophe reinsurers — was pressured by excess capacity and declining demand for reinsurance.

The report notes: “Margins will also continue to compress as third-party capital seeks a larger piece of the pie.”

To survive in this challenging environment, reinsurers will need to adapt and innovate, according to AM Best.

“Perhaps today, much of the third-party capital prefers property catastrophe risk,” the report continues. “In days to come it likely will spread to other lines of business and continue encroaching on reinsurers’ turf. Managing third-party capital, as many reinsurance companies already do, is one way to gain fee income and maintain control of the business.

“More creativity may be needed in the long term to stay relevant, and reinsurance companies also will have to spread into other lines of business. Third-party capital may be threatening the reinsurance segment, but that threat acts like an adrenalin shot to the heart where ‘fight or flight’ instinct takes over to ensure survival.”

In the catastrophe market, the report notes that there were large differences between insured losses and economic losses — and this represented an opportunity for those who could innovate to come up with products to address the gap.

Despite the lingering low interest rates that have trimmed returns from reinsurers’ investment portfolios, the report noted no large-scale shift by traditional reinsurers to riskier assets such as equities or alternative investments, though it did note that the average allocation of equities in reinsurers’ portfolios had risen from 2.7 percent in 2008 to 5.4 percent through the first three quarters of this year.

This meant that reinsurers had not been major beneficiaries of the rising stock market, although it had helped to improve price-to-book valuation of publicly traded reinsurers.