Pension fund capital inflows could dampen returns over time: KBW

by Artemis on March 7, 2013

Pension funds continued and growing interest in deploying capital into alternative structures in the insurance and reinsurance space brings with it a risk that it could change the rate environment for what some other investors may see as the worse. An analysts report from Meyer Shields of Keefe, Bruyette and Woods discusses this issue and warns that the incremental capacity that pension funds are bringing to the space could dampen returns.

The investment outlook that pension funds come into the re/insurance and insurance-linked securities (ILS) space with is one with a longer time horizon, compared to other institutional investors such as hedge funds, explains the report. Because of this the capital may exit the space much more slowly which could translate into a dampening of rate increases and the potential for lower returns over time.

This is very interesting as we are already seeing these trends in the reinsurance and ILS markets. The rate environment has certainly become less ‘peaky’ since third-party capital inflows have increased and regular readers will be aware that recent catastrophe bonds have seen price reductions before transactions complete as high demand from investors helps to make deals cheaper, and as a result returns lower.

We know that some dedicated investors in the space see this as a threat to the returns their strategies seek and there are many who would remove capital from the space and look elsewhere for opportunities if returns declined too far. However there are also plenty of investors who appreciate the qualities of reinsurance and catastrophe risk as an asset class too much to worry about a slight reduction in returns. Were the reduction in returns to become more permanent though there might be more issues with capital flowing outwards, but we do believe that many of the risks which are ceded to the ILS and third-party capital backed reinsurance space deserve a certain level of premium in return for assuming these peak risks.

KBW’s report is timely as it hits just as the sector is considering exactly these issues. There was a lot of discussion of returns and recent price reductions at the SIFMA IRLS conference in New York this week. How exactly these trends pan out over time is hard to predict, but there is certainly an impact on pricing and returns which is being caused by capital inflows from third-party sources.

One of the factors that KBW like about catastrophe insurance and reinsurance is the way that capital had been swift to enter and exit the space, which it thinks explains the sectors more moderate pricing cycle despite volatile losses of late. Pension funds though, it says, have a longer investment horizon than hedge funds which with the slower capital exit, even when return expectations are deteriorating, will KBW believe translate into worse returns.

Fundamentally, KBW suggest that third-party capital returns could trail the returns of the first-party insurance industry, but it notes that the third-party capital has yet to be tested by a major loss so its resilience is uncertain at this time. Temporary capital options should help to limit the number of new company formations with stickier capital, so KBW does say that it’s not all negative, but says that it may have underestimated the risk of third-party capital to rate adequacy and stability.

Very interesting insight from KBW and totally inline with many sector insiders opinions and concerns on the space at the moment. Whether third-party capital negatively affects rates now is almost a given, the changing face of the reinsurance market driven by inflows of outsider capital is certainly having an impact. It’s whether the impact on rates continues or gets to a stage whereby concerns emerge over risk-based pricing that the sector needs to be aware of. Diligence and an honest approach to pricing are key to ensure that the allure of capital doesn’t mean risks are underestimated and underpriced.

Of course, we would add that, the changing market as lines blur between capital markets capacity and traditional reinsurance capacity was always going to result in concerns about rates and returns over the longer term. At this stage of this evolution of the reinsurance market it is difficult to predict the trajectory of these going forwards. Certainly a less ‘peaky’ rate environment is likely, although a large Florida hurricane could change everything there, but the market will still cycle to some degree no matter how much capital flows in so perhaps it just needs to adjust to the new environment? What do you think? Let us know in the comments below.

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