Alternative reinsurance vehicles attracting an array of capital providers: A.M. Best

In our latest article looking at reports on the reinsurance sector from rating agencies, we look at A.M. Best’s special report ‘Reinsurers Show Resilience Under Weight of Catastrophes, Economic Woes’. In it A.M. Best says that the financial position of global reinsurers today shows the sectors financial resilience through 2011 which was one of the costliest catastrophe years in the reinsurance markets history. The report also looks at sources of capital which have been flowing into the non-traditional reinsurance sector.

Interestingly, Best says that 2011 showed that European reinsurers managed to maintain capital better perhaps than reinsurers in Bermuda and the U.S. However underwriting performance was ‘eerily consistent’ between the two groups of reinsurers, with European reinsurers who sometimes had more exposure in loss affected areas demonstrating that they benefit from a larger capital base and better diversification across global business lines. In particular the European reinsurers have larger life operations which can help to bolster their income and capital base while catastrophe lines of business are loss making.

Bermuda is more exposed to catastrophe shock type losses, as the island still focuses predominantly on property catastrophe reinsurance business. Best says that while underwriting performance was comparable between European and Bermudian reinsurers, the Bermuda companies took a larger relative share of shock losses in 2011 than European reinsurers.

The report discusses the trend for hedge funds to back or start-up their own reinsurance vehicles. Best says that this seems to be a result of the difficult investment climate, with these reinsurers looking to augment returns with their hedge fund strategies. There’s also an element of the hedge fund managers seeing a new source of capital for their funds and a way to leverage reinsurance premiums to increase inflow to their funds which might be more ‘sticky’ capital. As A.M. Best says, it will be interesting to see how this strategy performs across the underwriting cycle in years to come, as the more flexible nature of the capital allows them to allocate capital to underwriting when market conditions are most conducive.

A.M. Best’s report discusses pricing and rates in detail across the 2012 renewal periods so far. On this they say reinsurers have not seen the rate rises many were expecting earlier this year, but overall the market appears to be in transition with rates gradually improving. This means reinsurers are operating conservatively, not going after every premium opportunity they can find. Reinsurers are showing discipline and there is a need for careful selection of risk, geographic and product diversification and strong underwriting discipline. Best says it may be a while before the next full-blown hard market arrives as the current cycle is proving to be more gradual. Reinsurers who maintain a strong, well diversified, global book of business and stay disciplined should continue to perform well.

The report then moves on to look at the impact of alternative capital providers on the reinsurance sector. A.M. Best says that despite the global reinsurance industry remaining well capitalised after 2011’s catastrophes, plenty of interest remains and there is real activity in the convergence space of sidecars, catastrophe bonds and collateralized reinsurers. These alternative reinsurance vehicles, Best says, are attracting an array of capital providers such as pension funds and hedge funds who are joining more traditional private equity players in the reinsurance sector.

Best says that sidecar capacity appears to be adequate, as those that formed at the end of 2011 were fully deployed at the 1st Jan renewals. Only a few have come to market since then, perhaps suggesting that sidecar capacity is sufficient for the moment, with those that have formed being region or line of business specific.

The flow of capital into vehicles like sidecars and cat bonds augments the markets capacity, but sidecars themselves do not radically alter the reinsurance landscape, says Best. They say that the ease of entry and exit is a factor that attracts capital from investors such as hedge funds, pension plans and investment banks, making sidecars more popular than reinsurance startups in some cases. From a corporate earnings perspective Best says that sidecars with non-permanent capital seem more welcome than a new class of startups bringing permanent capital into the reinsurance sector. See our, related earlier article on where new capital has been going here.

While sidecars can be an expensive option Best says, they may be a better fit for investors seeking high returns, but not interested in market share, such as hedge funds. They are looking to deploy capital into something profitable which offers them a non-correlated source of return which can help to hedge their other investment assets. Best notes that hedge funds see reinsurance as something unique that has become increasingly scarce in other asset classes since the last financial crisis.

Pension funds are a growing source of direct capital for the reinsurance industry, says A.M.Best. The scale of pension fund assets means that the reinsurance sector only needs to encourage a small amount to enter the space to give them a big increase in financial flexibility. Hence this capital in particular can have the capacity to influence the reinsurance underwriting cycle and reinsurance rates.

The staying power of pension fund capital in the reinsurance and catastrophe bond space has yet to be tested, notes Best, saying that they see investment in alternative reinsurance vehicles as in the ‘greed stage’ of the life cycle. The ‘fear stage’ Best says could be as close as the next major catastrophe loss. That is an excellent point and something that the sector will need to work to head off by ensuring pension funds investments in the sector are well diversified. Thankfully, due to the greater availability of information on reinsurance alternatives such as cat bonds, pension fund managers are becoming better educated and deploy capital to the sector fully aware of the risks. The sector needs to ensure this continues.

A.M. Best notes that there is still an element of fear about the cat bond space, with funds nervous about the blame game that could ensue after a catastrophe event that triggered bonds. That can only be solved by education and greater diligence and transparency in transactions, areas that the market continues to focus on. Demand for cat bonds, however, outstrips supply and issuance cannot keep up, says Best, citing the example of Everglades Re Ltd. with its $750m of risk capital and 32 investors.

The report contains much more insight on issues such as taxation around the world, the Eurozone crisis, regulation and developing markets. You can access the full report via A.M. Best’s website here.

Here are a few of our other recent articles on similar topics:

– New capital and ‘competitive convergence’ credit negative for reinsurers: Moody’s

– Investors more interested in catastrophe bonds and sidecars than new reinsurers: S&P

– Global reinsurer capital up 5% to $480 billion: Aon Benfield

– Reinsurance industry able to withstand larger loss thanks to capitalisation: Fitch

– Capital market alternatives to reinsurance are increasingly viable and sustainable: Fitch

– Collateralized reinsurance capacity is disrupting the traditional market