Stickiness of third-party reinsurance capacity remains questionable: A.M. Best

by Artemis on April 19, 2013

Ratings agency A.M. Best raises questions regarding the stickiness of some third-party reinsurance capacity in its latest special report on the global reinsurance industry. The report looks at how despite increasing competition in the reinsurance sector and an economic environment making obtaining investment yield extremely difficult, reinsurance capacity keeps on growing with inflows of third-party capital into alternative reinsurance structures contributing to that growth.

A.M. Best says in the report that the over-capitalised nature of the reinsurance market is making it difficult for reinsurers forced by low investment yields to look for improved margins on the property and casualty business they underwrite. Competition has increased due to the high levels of capital in the space with new competition coming from third-party capital managers and alternative reinsurance strategies.

An additional threat to reinsurers is the trend for primary insurers to retain more risk or purchase reinsurance cover higher up in the risk spectrum. This is also, we understand, causing primary insurers to look more closely at more structured or capital markets backed sources of coverage which are sometimes easier to customise at these higher layers and also becoming comparatively cheaper than some sources of traditional reinsurance cover.

A.M. Best says that it is ironic that just as investment return and underwriting opportunities are waning the reinsurance market has attracted new capital to a market already saturated with it. Best says that investors and money managers have been enticed by the potential for relatively favourable returns from P&C reinsurance which are largely uncorrelated with broader financial market movements.

The report notes that some investors use the reinsurance sector to generate cost-free investment float, this is something many hedge fund backed reinsurers are targeting. However, the report notes that underwriting ability is key here, the business underwritten when looking for float needs to (generally) be lower volatility to enable the float to be reinvested.

Best says that investment managers have been courting underwriters to establish sidecars as one way to access the business. However, A.M. Best is slightly cautious on some strategies, saying “The matching of underwriting profit with a nontraditional asset strategy can, in theory, produce a relatively lucrative return, if all the stars align.” Best adds; “It is not yet clear how these strategies will work out over the longer term.” It’s worth pointing out here that while this is certainly a consideration that investors and money managers need to take into account, it is not stopping them deploying capital and the same can be said about many other asset classes and investment strategies.

For reinsurers who choose to embrace third-party capital and alternative reinsurance capacity there are benefits in obtaining greater flexibility with their own capital resources through the underwriting cycle and also fees to be earned through management of capital and profit-sharing.

The downside, A.M. Best says, is that additional capacity only makes reinsurance pricing more competitive, so reinsurers adopting a third-party capital strategy may be impacting the profitability of their traditional reinsurance business. Of course there is also the opposite angle that if you don’t get involved here you risk pricing becoming more competitive with no way to recoup the benefits of fee income and profit-sharing.

The other downside, according to A.M. Best, is that we don’t yet have any proof that this third-party capital is going to be sticky. Best note that the reinsurance market has long prided itself on the value of long-term relationships between underwriters and clients and that should third-party capital decide to exit the market suddenly, reinsurers could have some explaining to do and that this could pose a reputational risk.

As we’ve said before, there is no evidence as to how sticky capital markets capacity will be, it hasn’t yet suffered dramatic losses from a series of major catastrophe events or faced a really soft market yet, and nobody can predict how it will react to such scenarios. However, the anecdotal evidence from a number of types of investors, investment managers and reinsurers operating third-party capital management strategies, is that some capital may well exit but more is likely to seek to enter the sector if that occurred. We’re also told that more and more of the alternative reinsurance capacity is now being supplied by investors with a much longer-term investment horizon than had historically been the case, such as major pension funds, and this is a trend that is likely to increase.

A.M. Best says that capital management for reinsurers is now becoming about managing their own enterprise capital alongside third-party capital, throughout the reinsurance cycle. Third-party capital allows reinsurers to become underwriting managers as well as bearers of risk they back with their own enterprise capital, but A.M. Best rightly notes that reinsurers must remain vigilant with their own capacity to be well positioned for future potential market opportunities.

Finally A.M. Best also rightly points out that the influence of the capital markets and third-party capital in the reinsurance sector will likely ebb and flow as the market moves through underwriting cycles and the global economic climate changes.

Some third-party reinsurance capital definitely has questionable stickiness. Some third-party reinsurance capital is definitely in the reinsurance market for the longer term. It is the mix between speculative third-party capital and sticky third-party capital that will change as the markets move, but it looks safe to assume that both are becoming a feature of the reinsurance market that are likely here to stay.

You can access the full special report on reinsurance capacity growth from A.M. Best here.

Subscribe for free and receive weekly Artemis email updates

Sign up for our regular free email newsletter and ensure you never miss any of the news from Artemis.

← Older Article

Newer Article →