Reinsurers had a “miraculous” year of strong profitability in 2013 — despite a slew of challenges which ratings agency AM Best expects to weigh on the industry’s future prospects.

In its special report on the global reinsurance sector, entitled “Could 2013 be the apex of the next few years?”, Best reports that the global industry managed a 13 percent return on equity last year — a “phenomenal result” — helped by a lack of catastrophic events.

Over the past five years, Best ranked the US and Bermuda reinsurance industry as the top performer in terms of underwriting profitability. With its combined ratio (the percentage of premium dollars spent on claims and expenses) of 93.2 percent over the period since 2009, the region outperformed both Lloyd’s (93.4 percent) and the big European reinsurers (96.2 percent).

However, Lloyd’s is the big winner on return on equity with a five-year average of 12.3 percent, compared to 9.8 percent for both US and Bermuda, and Europe.

Despite maintaining a stable outlook on the industry, Best expects to re-evaluate that rating at mid-year renewals when the largest property-catastrophe reinsurance business is done in time for the US hurricane season.

Among the challenges Best sees for reinsurers are competition from the burgeoning influx of third-party capital, greater retention of risk by primary insurers and mediocre investment returns as a result of historically low interest rates.

Best wonders how the alternative capital would react if the pressure on rates were to continue and suggests that a major US catastrophe may stabilise the market.

“It seems ironic that as underwriting opportunities have waned, the reinsurance sector has attracted additional capital to a market already saturated with it,” the report states. “Is this smart money or is it naive?

“It’s no secret that investors and money managers are enticed by the non-correlating aspects of the property catastrophe business and the tax advantages gained by being an active offshore reinsurer. The insurance business also offers the potential for generating cost-free investment float, which appeals to money managers looking to increase assets under management and reap the lucrative fees that come with that. However, the key to cost-free float is the ability to generate an underwriting profit, which is not easily achieved and especially difficult in a soft market.”

Several hedge-fund backed reinsurers, such as Third Point Re, have set up in Bermuda with the aim of taking greater risks on the investment side, while underwriting conservatively.

Best notes that “convergence capital still appears to be in its early stages” and the impact on the reinsurance market is apparent.

“There are early indications that underwriting restraint may be waning as competition from alternative capital intensifies,” Best states. “The supply/demand equation of too much capital chasing the same opportunities has not only put pressure on reinsurance pricing, but also placed focus on reinsurance terms and conditions.

“The recently concluded April renewals revealed a worse than expected outcome for reinsurers as the abundance of worldwide capacity weighed on negotiations.”

The pressure on investment returns is illustrated by Best’s global reinsurance composite, which showed that total investment income fell from $31 billion in 2009 to $25.3 billion last year — a decrease of more than 18 percent.

Investment income is a “critical component of sector earnings and serves as ballast during periods of volatile underwriting”, Best notes. Most companies have responded defensively to interest rate risk by keeping the duration of their fixed-income portfolios short. However, reinsurers were showing more interest in “engaging alternative asset strategies” to generate more yield.

“They appear to be approaching this aspect of risk with caution, allocating a small share of excess capital to such strategies,” the rating agency added.

It highlighted the example of Watford Re, a new Bermuda-based casualty reinsurer that has raised capital of more than $1.1 billion, which opened its doors for business last week. Watford Re is backed by hedge fund High Bridge Capital and uses Bermuda-based re/insurer Arch Capital as its underwriting manager. Best said the company appeared to be “a forerunner in this evolution as it relates to longer tail casualty business”.

“In theory, this vehicle should have greater flexibility to write long-tail classes because of its higher return from investment activities,” Best states.

“Higher asset returns usually mean greater risk. It is not yet clear how well received this model will be among clients who want absolute certainty that the relationship will still exist five to ten years down the line.

“Having an affiliation with a well-regarded and disciplined underwriter such as Arch is certainly a positive in this regard, but how many Arch Capitals are out there?”