Alternative capital a disruptive force in reinsurance: Goldman Sachs

In a recent report, Goldman Sachs highlights alternative capital in reinsurance as one of eight disruptive themes in business today which it believes has the potential to reshape its sector and command an increasing level of attention from investors over years to come.

Goldman Sachs discusses eight innovations in the report, which it believes are either set to transform existing markets or open up entirely new ones, through either innovation in product development or business innovation. These eight themes, Goldman believes, will offer investors a source of growth which is insulated from wider macro economic effects and will create significant value.

The fact that Goldman Sachs has chosen to include third-party capital and alternative capital in the reinsurance market as one of these key disruptive themes is testament to the change we have witnessed in the reinsurance market over recent years, as the wave of capital has been building. Goldman’s report suggests that these themes are just getting started and the disruption is only just beginning.

The eight themes covered in the report include; Cancer Immunotherapy, E-Cigarettes, LED Lighting, Natural Gas Engines, Software Defined Networking (SDN), 3D Printing, Big Data and Alternative Capital in reinsurance.

Goldman looks at these themes through the lens of ‘creative destruction’ a convention thought up by economist Joseph Schumpeter, which describes the way that economic development can arise out of the destruction of some prior economic order. You can also think of creative destruction as innovation constantly driving change, pushing out the old guard and creating new opportunity within a sector.

Goldman describes the theme of ‘Alternative Capital’ as the rise of a new asset class which in turn means growing risk for reinsurers. Indeed, we have described this trend as disruptive, a new normal and a new paradigm for the reinsurance industry a number of times over the last few years.

Evidence that alternative capital is proving disruptive for traditional reinsurance firms is clear, with the mid-year reinsurance renewals showing the impact it has had on pricing and also forcing some reinsurers to fight back by easing terms and conditions for clients or offering greater flexibility.

Further evidence of this disruption can be found in the growing trend of traditional reinsurers launching capital markets and third-party capital management units, in an attempt to capitalise on alternative capitals march into the sector and ensure they don’t miss out on the opportunity it presents.

Goldman Sachs describes alternative capital flowing into reinsurance as the ‘rise of a new asset class’, bringing new risks to traditional reinsurers. With the backdrop of low interest rates persisting, Goldman cites the move into catastrophe reinsurance by pension funds and other traditional investors as a factor which is contributing to significant deterioration this year for reinsurers.

Goldman said that if pension funds increase their allocations into the reinsurance space, by allocating just a fraction of their portfolios to it, reinsurers ability to generate attractive, risk-adjusted returns alongside this alternative capital could be severely, and Goldman says permanently, impaired.

Goldman believes that alternative capital is approaching the allocation of capital into reinsurance in a different way to a traditional reinsurance underwriter. Third-party investors evaluate property catastrophe risk returns in the context of their overall portfolio and are willing to accept a lower return than traditional reinsurers have been able, or willing, to historically.

Third-party investors are attracted by the low-correlation returns that property catastrophe risk can bring to their portfolio as part of a balanced and diversified investment strategy. With much lower cost of capital, compared to a traditional reinsurer, this is allowing them to make deep impact on the reinsurance market quickly.

This alternative capital will dull the ability of reinsurers to push for rate increases, perhaps even after large losses. Alternative capital can enter the reinsurance market much more quickly post event and with its lower capital cost it may be able to deflect reinsurers ability to capitalise on rate rises and even deploy into reinsurance contracts at costs reinsurers would typically avoid. This may serve to flatten the reinsurance cycle, somewhat, and make any rate increases post-loss much lower than we’ve witnessed previously.

So, while reinsurers are worrying about issues such as capital intensiveness, profitability and the impact to return on equity and growth of book value, Goldman says that third-party investors are concerned with absolute yield, correlation and risk adjusted performance of their investments.

These two differing mind-sets are key factors which have placed the worlds of alternative capital investors in reinsurance and traditional reinsurers on a collision course, with disruption as good as guaranteed.

The question many are asking right now is whether an equilibrium will be reached, with each form of capital finding its own place within an already over-capitalised reinsurance market, or whether disruption and alternative capitals steady march into reinsurance will continue?

Goldman believes that as alternative capital continues to move into the property catastrophe reinsurance space traditional reinsurers will be forced to re-deploy capital elsewhere, spilling over into other lines of business and sectors.

Goldman said that some reinsurers could benefit from managing third-party capital themselves, hence the rush to establish capital market divisions, the fee income they earn from this may not be sufficient to replace lost underwriting income.

With property catastrophe offering the highest returns in the reinsurance market, generally, reinsurers who are forced to deploy capital elsewhere may find new business delivers a lower return on equity than they had been used to. Interestingly Goldman cites Berkshire Hathaway’s move into Lloyd’s, via its sidecar type full-follow agreement with Aon, as a way for Warren Buffett’s reinsurer to find new income from new market opportunities at a time when property catastrophe income may be declining.

While the inflow of alternative capital into the reinsurance space, via collateralized reinsurers, instruments such as catastrophe bonds, industry loss warranties (ILWs), sidecars and the gamut of insurance-linked securities (ILS) funds and solutions, continues apace, the sector is not seeing demand for cover pick up as rapidly.

This leaves a situation where traditional reinsurers may find themselves competing within property catastrophe reinsurance against capital which can afford to be deployed at lower cost and with no real increase in underwriting opportunities, a gloomy outlook for sure.

Of course, growth in property catastrophe reinsurance will come, that’s almost assured as primary insurance penetration expands globally, into regions such as Asia and emerging markets. However that growth as insurance premiums grow globally may not result in sufficient new reinsurance opportunities to satisfy the traditional market and alternative capital may target those same opportunities anyway.

Alternative capital in reinsurance has grown by approximately 800% from $5 billion in 2005 to the estimated $45 billion we see in the reinsurance market today. Goldman Sachs believes that there is more to come, as do most analysts, commentators and judging by comments from traditional incumbents, so do reinsurers.

If that’s not gloomy enough for traditional reinsurers who aren’t factoring third-party capital into their future plans and strategy, Goldman Sachs believes this is just the start. It believes that alternative capital will broaden its focus in reinsurance, likely beyond pure property catastrophe, as adoption improves. That bodes well for investors who will likely welcome the ability to diversify further within the reinsurance market.

Goldman expects the alternative capital trend to manifest in the following ways over the next few renewal cycles:

1. Direct impact (now) – continued pressure on property catastrophe reinsurers, particularly in U.S. focused renewals.
2. Indirect impact (6 to 12 months forecast) – reinsurers to either shrink or look elsewhere for opportunities. As reinsurers find their capital ‘crowded out’ of the market they will have either accept lower margins, look elsewhere (again likely resulting in lower margins) or shrink their books of business.
3. Further encroachment (12 to  24 months) – Alternative capital will move into other lines of business and geographical territories. If investors continue to appreciate investments in reinsurance, even when interest rates begin to recover, then Goldman expects alternative capital to begin to encroach on other areas of reinsurance.

Goldman Sachs then cites the fact that pension funds have so much capital available and currently are deploying so little into reinsurance, when you consider the trillions of assets they hold globally. So we could see significantly more capital move into reinsurance over the next 12 to 24 months if pension funds prove to be as sticky as most people now think.

It’s not all bad news for reinsurers though, as Goldman Sachs sees opportunities for them to continue to be profitable. One possible outcome of this is that reinsurers move to a fee income based model, utilising underwriting expertise to generate income from third-party capital more efficiently.

If this becomes necessary we could see major disruption in the reinsurance market, resulting in down-sizing of operations as reinsurers seek to become lean managers of capital or lean centers of underwriting expertise that alternative capital can leverage. Either way that would likely necessitate major change in reinsurance market dynamics.

A second possible outcome that Goldman Sachs mentions is one where investors lose interest in reinsurance as an asset class and incumbent reinsurers are able to regain control of market share and once again influence pricing and rates.

For this second outcome to manifest itself it will take a major event, a major crisis of confidence or a major increase in the return of other asset classes we believe and even then some investors will likely stay the course. Also this outcome is some way off and reinsurers may have adjusted to the new paradigm of alternative capital by then, meaning that adjusting back could be a difficult and costly process.

Whatever the outcome, the next few years looks destined to be a period where alternative capital continues to find its feet in reinsurance. It is still early days, the pension fund market is still learning about ILS and reinsurance as an asset class, meaning that this disruption is likely to continue.

Reinsurers will learn to cope with the changes that they are facing and some will emerge stronger, leaner, centers of reinsurance underwriting expertise as the alternative capital disruption continues to become the new normal.

In future we may have to think about a number of functional areas in the reinsurance market; origination – dominated by brokers but with ILS and reinsurers increasingly able to self-originate when necessary, risk analysis and actuarial – risk modelling firms but also expert reinsurers, underwriting – the domain of the reinsurance company and specialist ILS managers, and capital – in whatever form and from wherever it may be sourced.

Capital and underwriting may become even more abstracted than we are currently seeing, with underwriters becoming increasingly agnostic as to the source of capital and shareholder equity no longer being considered more valuable than external, or alternative, capital.

One other piece of this puzzle that needs to be considered is of course cedents. Alternative reinsurance capital needs to find ways to mirror the service and contractual features that cedents are used to from traditional reinsurance coverage. Here is a real opportunity for incumbent traditional reinsurers, find ways to pull third-party capital into structures and contracts that satisfy all cedents at all levels of their reinsurance programs.

Of course, we cannot predict the future and neither can Goldman Sachs, but its report does paint a plausible picture of where the alternative reinsurance capital trend is going. Whatever way this does play out over the next few years, one thing is certain, alternative capital is already, and will continue to be, disruptive to the reinsurance sector.

You can read the full report on the eight disruptive themes from Goldman Sachs via the Zero Hedge website here.