It looks like one of the hot topics of conversation at Monte Carlo this year is the convergence of the reinsurance and capital markets. That area we cover where non-traditional reinsurance alternatives such as collateralized vehicles, catastrophe bonds and insurance-linked securities, sidecars, third-party capital and direct investor participation in the reinsurance and retrocession markets are the risk transfer tools of choice. Reinsurance broker Guy Carpenter is more bullish than most on this and believe that its time to accept that non-traditional capacity is here to stay.
This year has seen a swing in the opinions of many in the reinsurance market. Historically it had been believed that non-traditional capacity and capital sources were opportunistic and only dipping in and out of the reinsurance or retro markets as and when rates were attractive and there was a high return to be made. This year seems to be disproving that as capital has continued to flow into the sector even as rate rises have slowed and catastrophe experience has been much more affordable. Hence the convergence part of the reinsurance and retro market was seen as something that expanded when market conditions were good and then contracted again when conditions were not so attractive. Not any more, say Guy Carpenter, it’s time for market participants to adapt to an evolving reinsurance market where capital market capacity becomes a more permanent feature.
In a press briefing held yesterday, David Priebe, Vice Chairman of Guy Carpenter, discussed the expanding role of the capital markets in reinsurance and retro business.
“We have been talking for a long time about the convergence of the capital markets. But I believe the reinsurance market has come of age and that the old distinction of traditional and non-traditional sources of capital is redundant. The market has converged.”
He cited a number of reasons for this convergence becoming the norm within reinsurance. He said that price differences between non-traditional sources of capacity and traditional sources have no narrowed, making the capital markets backed solutions price-competitive with traditional reinsurance and retro cover. As soon as prices began to converge there was always going to be a speeding up of the convergence effect as many of the non-traditional solutions have added benefits such as a multi-year nature. These new markets have become more competitive at providing large amounts of capacity and the understanding of the basis risk involved is improving. On the execution side Priebe said that transactions are now much smoother, quicker and cheaper. All of these factors have helped the non-traditional sources of capacity become more sticky.
Priebe continued to say that large buyers of cover now view the whole convergence landscape as part of their core reinsurance and retrocession programs, not purely as fillers to take advantage of when the price and conditions were right. Large buyers now structure their core reinsurance and retro to take advantage of all available products, he added. This is a trend we can verify as we regularly see evidence of large reinsurance programs being restructured to fit in a layer of collateralized or multi-year cover from non-traditional sources.
There are many advantages to the non-traditional products, Priebe said, including giving cedents, sponsors or buyers access to large amounts of capacity, the collateralized nature of the products which can effectively reduce buyers credit risks, the effective diversification of counterparties and sources of cover, and the provision of reinsurance capital to improve solvency or promote growth.
On the investor side, Priebe said that they continue to be attracted to the risk and return profile of the insurance and reinsurance sector, and the wide variety of different ways to put capital to work, such as ILS and cat bonds, funds, collateralized vehicles, sidecars and third-party capital plays, also contribute as an attraction. This is an important point and one which the market needs to remember. By keeping the methods of deploying capital broad, the sector will be able to attract significantly more capital as not all investors want their cash locked up for long periods. Investors have different goals and desires and if the non-traditional reinsurance space can continue to cater to as many as possible it will help the capital continue to flow.
Guy Carpenter estimates that the property-catastrophe reinsurance sector includes as much as $34 billion in capital from non-traditional sources at the middle of this year. That number is inline with other commentators who put the contribution of the capital markets in underwriting risk as between 10% to 15%.
Priebe said that the catastrophe bond and insurance-linked securities market remains robust and he see’s the market closing in on the high-point (of risk capital outstanding) set in 2007. He noted that since that high-point the amount of risk capital outstanding in the cat bond and ILS market has rarely dropped below $12 billion, which demonstrates the instruments longevity as a source of reinsurance and retro cover.
Guy Carpenter expect the tight pricing trends that we’ve seen with cat bonds since June, where they have priced at the lower end of expectations, or even below expectations (as Eurus III just has), will continue over the rest of the year. That is encouraging as tighter pricing makes cat bonds and ILS more competitively priced and cheaper for the sponsors, it also shows that investors are becoming more confident and willing to accept risk for slightly lower returns.
Priebe said that the cat bond and ILS pipeline remains strong for the remainder of 2012 and he said that the active forward pipeline contains a number of non-U.S. peril deals. That will please investors as the one area this market needs to offer more of is diversification within its own mix of transferred risks.
By the end of 2012 Priebe said that Guy Carpenter expects cat bond and ILS issuance to exceed $6 billion, inline with most other forecasts and with our own market poll (which you can respond to here). If the market does achieve that level of issuance in 2012 we will see the amount of cat bond and ILS risk capital outstanding exceed $15 billion, he said. Priebe also noted that he expects to see further growth in sidecars, collateralized reinsurance entities and dedicated retrocessional vehicles.
Part of the reason for the increased participation of the capital markets and their becoming a permanent fixture in reinsurance is the lower returns re/insurers have been able to offer investors recently. Non-traditional reinsurance and retro consistently offers investors high returns and non-correlated investment opportunity unlike re/insurance equity investments which are lower return and suffering due to the economic environment. The new money that entered the market this year has helped to limit the firmness of the reinsurance market, said Guy Carpenter.
Guy Carpenter estimates that between $6 billion and $8 billion of new capital has flowed into the non-traditional side of the reinsurance market since the 2011 catastrophe year, and that alternative markets provide around 14% of property catastrophe limit purchased. Penetration of this capital is growing as fund managers with scale and proven track records providing high-yielding, non-correlated investment opportunities continue to attract new capital.
Anecdotally we hear of a number of fund managers who have recently attracted new capital and are now keen to deploy that capital even in advance of the January renewals. That could offer some buyers an opportunity to secure capacity sooner rather tha later.
Guy Carpenter says that the new generation of fund managers are able to offer comparable products and sometimes more competitive pricing than traditional reinsurers, due to expectations of a lower cost of capital and return. The new generation of institutional funding that helps this now converged sector to grow is also coming into the market with a longer investment horizon. Hence, Guy Carpenter says it is likely to become a permanent and growing source of capacity for property catastrophe reinsurance buyers.
On the hedge fund side of reinsurance, Guy Carpenter highlight the strategy of some of these more opportunistic investors. Some are seeking market dislocations, they say, to target returns in the low 20% range on an expected loss basis and the high 30% range on a no loss basis. They are finding these rates primarily in the retrocession markets. With returns of that magnitude available it is no wonder capital is coming in at this opportunistic level as well as the lower return collateralized plays.
The investment banking arm of Guy Carpenter, GC Securities, says that its clients are “challenging the traditional reinsurance model”. Some are establishing operations to attract capital from third-party investors to them which they can then deploy as underwriting capacity, this is similar to the operations of Renaissance Re and Validus Re.
This could result in some established, traditional reinsurers moving into competition with the ILS fund managers and collateralized reinsurance vehicles. Guy Carpenter notes however that a third-party fund vehicle managed by a reinsurer may not be as attractive to some large investors such as pension funds and mutual funds, as they may not meet with the same governance requirements. However the added benefit of underwriting and claims management experience as well as reach may offer reinsurers a competitive advantage.
The coming six to twelve months are going to be telling for this trend of capital markets backed capacity increasing its foothold in reinsurance and retro protections. The January renewals will be intriguing, as will the next six months or so for cat bond issuance. There is a chance that the capital markets backed arena could grow significantly if pricing can be kept comparable with traditional reinsurance covers. We expect reinsurers will find ways to embrace this convergence of the two markets by innovative uses of non-traditional products and finding ways to offer them to their client base. Quite how this will affect the reinsurance landscape in the future is hard to say but we could see fund managers teaming up with reinsurers to leverage the underwriting experience and breadth of expertise. Having the right fund managers teamed up with the right underwriters could make for a powerful combination with an ability to attract significant sums of capital.
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