Alternative capital improves re/insurance capital efficiency: AIG’s Hancock

Some risks are more suited to the traditional reinsurance model, where underwriter skill and experience are crucial, but there are certain risks that are better in the capital markets where capital efficiencies can be realised, according to AIG’s Peter Hancock.

Hancock, CEO of AIG Property Casualty, spoke recently at Sanford C. Bernstein’s annual Strategic Decisions Conference 2014. The conference in its 30th year features leading executives from some of the largest corporations in the U.S. and the world, who offer to speak about their strategies and be quizzed by Alliance Bernstein analysts.

Peter Hancock discussed AIG’s underwriting and the evolution of the firm since its bailout by the Federal government. With underwriting capacity increasingly becoming commoditised, one of the topics Hancock discussed at some length was the influence of alternative reinsurance capital and insurance-linked securities (ILS), how it is affecting the insurance and reinsurance industry and how AIG regard it.

Hancock said that AIG views the entry of new capital into the reinsurance market, from third-party investors and institutional sources, as an opportunity for its customers. AIG sees it as a trend in the reinsurance market that should be embraced in order to continue providing its customer base with the best product it can.

Hancock said that some risks are better suited to the capital markets than others. “No doubt that there are certain risks where underwriters with experience, engineering and data analytics are best, but there are certain risks that are better redistributed to the capital markets,” he explained.

AIG is itself a user of ILS in the form of catastrophe bonds, having sponsored a number of transactions over the years. It likely also uses an element of alternative capital via collateralized reinsurance as well, given the size of its reinsurance program it’s almost inevitable that some of the larger ILS managers will be participating on a collateralized basis.

“We have embraced the use of insurance linked securities and cat bonds to a greater extent than any other insurer, we have more cat bonds outstanding than anybody else and we see it as an important supplement to traditional reinsurance,” said Hancock.

That statement actually isn’t quite true, at least not based on our numbers from our catastrophe bond and ILS Deal Directory. In fact we calculate that both USAA and now Citizens Property Insurance Corp. have a greater volume of risk capital outstanding in catastrophe bond form currently and USAA has certainly issued more cat bonds over the years than AIG.

Despite AIG’s liking for catastrophe bonds it is not turning its back on the traditional reinsurance market, Hancock insisted, rather it is leveraging the lower-cost of capital to support its offering to its customers. “It’s not that we’ve abandoned reinsurance but we certainly embrace this capital source as a way to offer cheaper capacity to our customers and make us competitive going forwards,” he commented.

Hancock believes that ILS and alternative capital is here to stay in reinsurance, saying; “I think that that is a phenomenon that is here to stay. Sure some of the volume may be elevated as a result of quantitative easing and the chase for yield among investors looking for non-traditional asset classes, but some of it will be here for the long-term.”

However there are improvements to be made, Hancock said. AIG has pushed the envelope with its recent Tradewynd cat bond deals, including unmodelled and complex industrial risks that were rarely seen in the cat bond market before.

“I think there’s a lot of improvement to be made in the design of those securities to be a more sustainable and cost-effective source of capacity and it’s still very heavily concentrated in U.S. cat property as opposed to more broadly applied to other perils,” Hancock continued.

Hancock said that he sees ILS and alternative capital as something that will benefit the industry and that he expects the current market environment, of too much capital chasing too little risk, will resolve itself in time.

He explained; “I think it’s a phenomenon that will improve the capital efficiency of the industry and I think whatever short-term mismatch there might be between capital and capacity and demand in insurance will be overtime overcome by the growth in demand for insurance in emerging countries.”

Hancock said that he expects the growth will come from the pace of urbanisation in China and other developing countries, along with the under-insurance in those countries which give plenty of room to soak up that excess reinsurance and capital market capacity as those markets mature.

On the current market environment, Hancock said that he does not expect it to be a typical soft market. AIG will continue to leverage new forms of capital to keep itself competitive, he said, by using cheaper capital from alternative sources, side by side with AIG’s own capital.

Interestingly, Hancock mentioned fixed costs, or expenses, as a key metric to watch in a soft market, something others have been avoiding discussing as yet but which we’ve been forecasting will likely come to the fore later this year for reinsurers if the current soft market and competitive nature of alternative capital continues.

Hancock explained; “Probably the single biggest weapon for managing a soft market is focus on fixed cost. If you have high fixed costs the temptation is to try and write dumb business to try and cover your cost base and you’ll regret it later. So removing that temptation by having a very strong focus on your fixed cost base, I think, reduces the temptation to write marginal business.”

With reports from the recent reinsurance renewals suggesting that some underwriters (traditional and alternative) may be writing business in a less than diligent way to maintain premium levels, it will be interesting to see whether expense ratios and fixed costs do come more into focus towards the tail-end of this year.