There have been many claims that alternative reinsurance capital, or capital from insurance-linked securities (ILS), is less rational than traditional reinsurers when it comes to underwriting. Recently though, it is beginning to look the other way around.
Alternative capital and ILS providers have been blamed for pushing down reinsurance prices, accepting too much risk for too little reward and for being generally irrational when it comes to underwriting. These aren’t claims we’ve ever subscribed to, having striven to point out that ILS has a reduced cost-of-capital and return hurdle than the traditional reinsurance market.
This idea seems to be spreading now, with others highlighting the low-cost of ILS capital, the broad expertise and underwriting skill of the majority of dedicated ILS players and the ILS managers ability to accept a lower return for underwriting the same business as a traditional reinsurance company.
In its latest report on the European reinsurance market, Kamran Hossain an analyst from RBC Capital Markets, highlights some very telling points regarding the recent trends in reinsurance, saying that reinsurers find themselves in the doldrums with no sign of being able to achieve the super-normal margins and returns they’ve enjoyed in recent years again in the near future.
These super-normal returns and margins, which reinsurers have been earning since 2011, have no disappeared and are unlikely to re-emerge, in RBC’s view. Of course these record returns are largely responsible, alongside low catastrophe losses, for helping traditional reinsurers to accumulate such large amounts of capital, resulting in the over-capitalised sector we see today and exacerbating the pricing pressure being felt.
Alongside this the influx of alternative and ILS capital into reinsurance has helped to push catastrophe reinsurance pricing down to levels not seen in a decade and RBC believes that alternative capital will be increasingly utilised in the reinsurance market in years to come.
RBC believes that alternative and ILS capital has now reached its minimum return-hurdles on reinsurance pricing and as a result it does not expect that ILS will push pricing much lower. However, there may be further pricing competition to come from traditional reinsurance capital, as the record levels of capital combined with a need and desire to find new underwriting opportunities could lead to traditional reinsurers dropping prices further.
Further deteriorating the outlook for reinsurers is the fact that after a large loss event, which would need to be $135 billion plus in order to move the needle on pricing over multiple years, new alternative capital is expected to enter the sector therefore capping the upside which has been seen in the past on reinsurance pricing, according to RBC.
All these factors lead the RBC Capital Markets analyst to believe that reinsurance pricing will continue to decline at the January 1 2015 renewals, perhaps even by as much as was seen a year earlier at the last January reinsurance renewals.
On earnings, another light hurricane season may help to build book-value for reinsurers but will only further the pressure on pricing and the competition within the market. As a result capital returns may be a factor for large reinsurers, but M&A is expected to be restricted to the small to mid-sized reinsurers and RBC does not expect any of the European reinsurers to pursue non-life acquisitions.
While alternative capital and ILS has found, or is near to, a baseline in pricing, RBC does not believe that the traditional reinsurance industry, in aggregate, has the same discipline on pricing. RBC expects alternative reinsurance capital will continue to grow and now places an estimate for $70 billion of alternative reinsurance capital by the end of 2016, up from its previous estimate of $60 billion. We actually think, depending on market conditions, it could be a little higher.
The RBC analyst notes in the report that alternative capital, ILS and catastrophe bond pricing is not expected to decline much further, but what concerns them is that traditional reinsurers may put further pressure on pricing in an attempt to remain competitive while backed by record levels of capital.
Traditional reinsurers protestations that they will retain clients due to their expertise, long-standing relationships and large balance sheets may prove to be unfounded, according to the report. Buyers of alternative reinsurance and ILS products are expected to continue to increase and the pressure on traditional reinsurers to compete will remains as a result.
RBC expects ILS managers and capital will begin to narrow some of the gaps between economic and insured losses in emerging or frontier markets, with Asia a likely target. This is true, ILS managers may look to develop their own models to gain comfort in allocating capital to these sectors, while traditional reinsurers could risk being left behind as the more nimble ILS model allows for greater innovation and experimentation.
Brokers could also wield their influence resulting in a greater uptake of alternative capital and ILS, according to RBC. With brokers keen to push the most economic solutions for their clients when structuring reinsurance programmes, this could result in greater use of ILS capital in years to come.
The RBC report goes into some detail on ILS finding a baseline for pricing, as evidenced by recent price reports showing a leveling off of the market and a stabilisation of pricing as the mid-point of 2014 was approached. RBC notes that the capital providers behind ILS have many other asset classes they can look to and as a result deciding not to take any further price reductions on catastrophe bonds is a rational approach.
In fact, RBC says that it views alternative and ILS capital providers as much more rational on pricing than their traditional reinsurance counterparts. The lower cost-of-capital allows ILS to accept a lower return, but now that these low levels have been reached RBC does not expect it to go much further.
On the other hand, traditional reinsurers with large fixed cost bases and no option to deploy capital into other asset classes could actually end up being more irrational than the ILS and alternative markets, says the RBC report.
The desire and need to deploy and make us of the excess capital in the reinsurance industry could result in irrational behaviour. This may already have happened, in the relaxation of terms and conditions as well as the broadening of coverage offered, at recent renewals but it will take some time (and loss events) before we will really be able to understand whether discipline was indeed lost to a degree.
We have been saying for some time that ILS capital may be more disciplined than some people give it credit for. The evidence will be seen in times of losses, particularly unusual or unexpected loss events, when we may see some players, traditional or alternative, suffering outsized losses due to their willingness to compete at ever lower price levels and with ever broader terms.
In reality it is likely that discipline could be an issue on either side of the market. However, with ILS having seemingly begun to find the bottom of its price appetite, further evidence of a reduction in discipline or rationality may be provided by the traditional reinsurance market in its efforts to maintain the margins it has become accustomed to.
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