Consolidation and pricing pressure possible as reinsurance convergence continues

A new report on the U.S. and global insurance and reinsurance market published yesterday by Conning & Company suggests that as the convergence of reinsurance and capital markets continues to play out the trend will bring its own challenges for the industry to deal with. Competition, between traditional and alternative reinsurance players, will likely grow which may lead to consolidation and the increasing convergence could lead to pricing pressure and reduced returns.

Conning’s report, titled “U.S. and Global Insurance Industry Outlook: Economic, Capital Markets, and Regulatory Challenges Continue—Nothing to Be Gained by Waiting for Things to Get Better”, looks at the challenges that will face the insurance and reinsurance industry in years to come.

Conning says that key challenges facing the industry include continued weak economic growth, an extended period of low-interest rates which currently looks set to be the norm for at least a few more years, weak investment income resulting from poor rates and rising regulatory demands which increase operational friction.

“Insurers in the U.S. and globally face challenges that are unlikely to resolve in the short term,” commented Stephan Christiansen, director of research at Conning. “Sluggish economic conditions affect organic growth potential and overall market development. The continued low interest rate environment in the U.S. and elsewhere is depressing investment income substantially in all sectors. Regulatory change and reporting requirements, meanwhile, are forcing increases in infrastructure investment and costs generally.”

The problem is that currently there is no sign of any of these factors changing dramatically meaning that insurers and reinsurers need to begin to accept market conditions as a new normal in which they have to operate. Add in the realisation that catastrophe losses seem set to continue to rise, as the industry expands and global development and insured exposures increase exponentially, and it’s easy to see why some concerns arise.

“What had initially been seen as a period of post-recession malaise has now become our base-case for strategic and operational planning,” said Christiansen. “Insurers who took a ‘wait-and-see’ approach are now challenged to perform in these adverse conditions, as no clear end is in sight. Competition is increasing, and companies that succeed in this environment will seek performance in targeted strategies in particular geographic or market segments and will invest internally in technology for effective cost management and new market distribution approaches.”

So in a climate of ongoing change, with opportunities emerging in new regions and perils but opportunities declining in terms of ability to maintain investment incomes, the insurance and reinsurance sector is entering a period where Conning sees the potential for consolidation and accelerating change in the markets status quo.

Conning says in the report that companies who decide to meet these challenges head on will likely invest in their own operations, improving infrastructure and ensuring they become underwriting centers of technical excellence, embrace alternative distribution strategies, business models, capital management strategies and market approaches while also exploring investment alternatives.

Structurally the growth or capital market and third-party investor backed alternatives to reinsurance will force change and challenge the traditional reinsurance model, according to Conning. Investors have found the reinsurance-linked investment and insurance-linked securities (ILS) space an attractive, uncorrelated asset class with an opportunity to grow, leading to strong capital inflows to the sector in recent years and high interest from investors globally.

Demand for insurance-linked investment opportunities, such as catastrophe bonds, reinsurance-linked funds, sidecars, ILWs and other alternative reinsurance products continues to outstrip supply of these opportunities, which Conning says could result in an exertion of downward pressure on reinsurance pricing and rates.

Conning notes that traditional reinsurers are now responding to the challenge posed by capital market investors and ILS specialists by becoming cat bond issuers, forming partnerships with existing ILS and reinsurance funds or creating their own internal capital management functions to concentrate on raising third-party funds for ILS and instruments such as sidecars.

Conning said that it sees reinsurers working out how to offer innovative risk transfer solutions to clients while not losing business to the ILS and collateralized reinsurance market. The convergence of the reinsurance and capital markets is set to continue, says the report, but as competition heats up and an oversupply of capital continues, returns for both reinsurers and ILS investors could suffer due to the pressure this will exert on pricing.

Conning also sees a period of consolidation coming for the reinsurance market, saying that the climate seems ripe for mergers and acquisition in the U.S. and competitive pressures may increase the momentum for consolidation among Bermudian reinsurers as well.

Conning cites the hedge fund backed reinsurer model alongside the ILS and collateralized space as potentially driving consolidation. The growth of these alternative reinsurance capacity sources and the increasing interest in the sector from capital market investors, it says, could shrink demand for traditional reinsurance and retrocession, leading to growing pressure for consolidation among reinsurers.

That is a scenario which we are already beginning to see play out. We’ve yet to see the consolidation taking place en mass but the pressure is certainly being felt by traditional reinsurers at the moment and their interest in starting up their own third-party capital activities is testament to this. Whether M&A will be the result further down the line is hard to say. There is a chance that the market may find a new mid-ground where traditional reinsurance cover plays its role and alternative capacity sources begins to help finance it as well as the more specialist, peak perils and innovative side of the market. Whatever way this plays out it’s an interesting time to be involved in the space and the threat this poses to traditional reinsurance players should also be seen as an opportunity for them to adapt and find new business models which suit the high level of intellectual capital these companies hold.

You can purchase a copy of the full report from Conning via its website here.