AM Best is revising its outlook for the reinsurance sector to negative.

The ratings agency said that while reinsurers are currently financially strong, they continue to be squeezed by market conditions and low interest rates.

“It has become even more apparent that as compression continues bearing down on investment yields and underwriting margins, this strain on profitability will ultimately place a drag on financial strength,” Best said in its report yesterday.

Traditional reinsurers have managed to remain profitable in recent years, helped by a lack of claims from major catastrophes.

But reinsurance rates have fallen as a rush of alternative capital, in the form of insurance-linked securities such as catastrophe bonds, has poured into the market.

Best said “it remains difficult to stray from the simple fact that compressed investment yields, lower underwriting margins and broader terms and conditions place a strain on profitability, and that reinsurers are being paid less and less to bear risk”.

The agency said it did not anticipate making “a significant number of negative outlooks or downgrades over the very near term”, but added that the market headwinds at this point present significant longer-term challenges for the industry.

Bermuda is one of the world’s major centres of property-catastrophe reinsurance.

One impact of the convergence capital is that it may rush in to take advantage of high rates in the immediate aftermath of future major disasters, thereby removing some of the opportunities for traditional reinsurers to rebound from large claims payouts.

“Broadly speaking, rated balance sheets are currently well capitalised and capable of withstanding various stress scenarios,” Best noted. “However, over time this strength may erode as earnings come under increased pressure and grow more volatile, favourable reserve development wanes and the ability to earn back losses following events is prolonged by the instantaneous inflow of alternative capacity.”

Best suggested that some reinsurers had started to accept inadequate pricing for the risks they were taking on, in order to keep clients, something that the industry had largely managed to avoid up to now.

“All of these issues reflect increased concern that underwriting discipline, which until recently had been a hallmark for the reinsurance sector, is beginning to diminish as companies look to protect market share at the expense of profitability,” Best stated.

“Given where rate adequacy is, it will continue to take optimal conditions, including benign or near-benign catastrophe years, a continued flow of net favourable loss reserve development and stable financial markets, to produce even low double-digit returns.

“Such return measures would have been considered average or perhaps mediocre just a few short years ago. In our view, companies with diverse business portfolios, advanced distribution capabilities and broad geographic scope are better positioned to withstand the pressures in this type of operating environment, and have greater ability to target profitable opportunities as they arise. It also places increased emphasis on dynamic capital management in order for companies to manage the underwriting cycle and remain relevant to equity investors.”

Best first signalled the potential for a downgrade of the sector in a report five months ago.