Capital market alternatives a permanent fixture in reinsurance: Fitch

by Artemis on September 8, 2014

The capital markets, alternative risk transfer and alternative reinsurance capital is a permanent fixture of the global reinsurance market, having gained acceptance from both cedents and reinsurers, according to Fitch Ratings.

Alternative methods of risk transfer, backed by reinsurance capital from new sources such as third-party capital markets and institutional investors, are here to stay Fitch Ratings says in its latest pre-Monte Carlo reinsurance market report.

Both cedents and traditional reinsurance firms have accepted this new capital and forms of risk transfer as a structural change to the reinsurance market, principally in property catastrophe risk. In this group of ‘alternatives’ Fitch categorises, catastrophe bonds, collateralized quota share reinsurance sidecars, industry loss warranties (ILW’s), hedge fund backed reinsurance firms and asset managers investing in insurance-linked securities.

Fitch says it views the growth and acceptance of alternative reinsurance solutions as a strain on reinsurers credit quality, especially for smaller, stand-alone property catastrophe reinsurance firms. Fitch does note some positives for certain, specific companies, likely those that have managed to profitably leverage third-party capital to expand their underwriting. However the added competition and increased supply of capacity from the capital markets has resulted in a deteriorating profitability profile for the reinsurance sector as a whole, the rating agency explains.

Due to ILS’ focus on model-driven property catastrophe reinsurance business, returns on this segment of the market have declined the most and what was once considered adequate for the volatility risk assumed at 10% to 15% returns by traditional reinsurers is now being underwritten at single digit returns by capital market providers.

Fitch cites this as another example of the lower-cost of ILS capital, as the 6% to 10% return is still acceptable to a capital market backed ILS player with a lower capital cost than a traditional reinsurance underwriting firm.

Overall the benefit to traditional reinsurers from the added fee income and risk management tools, available by embracing third-party capital and ILS, are outweighed by the increased competition from capital market capacity. The reinsurance sector profitability profile is deteriorating, warns Fitch, as the new capital combined with excess traditional capital has forced price declines and broadening of terms on reinsurers.

Primary insurers on the other hand are benefiting, as cheaper risk transfer, more choice and more inclusive coverage have resulted in savings allowing them to increase their reinsurance protection or to add to earnings, improving their risk profile and expected returns. However, note Fitch, the same softening trend and excess capital is now starting to increase competition in the primary insurance market as well.

Fitch believes that alternative capital and ILS has now reached a critical mass whereby it will remain as a permanent fixture of the reinsurance market. As reinsurers accept this they look for ways to match client needs with the right form of capital, a skill that is going to make certain specialist roles in demand in years to come, this approach is necessary if reinsurers are to successfully navigate the market headwinds.

However, this does not benefit reinsurers credit quality, says Fitch. Any benefits from an additional, diversifed source of revenue tend to be outweighed or offset by the reduction in profitability on reinsurers core books of business. Fitch’s report explains:

While the alternative market can provide some level of benefit to reinsurers, it does not compensate for the reduction in earnings from the loss of underwriting business or the reduced level of market pricing.

The report notes that the trend is affecting all reinsurers, but the small and property-cat focused are once again singled out as most at risk. Fitch explains:

It will be imperative for these players to maintain strong underwriting discipline should market conditions continue to deteriorate. However, these reinsurers must also maintain a delicate balance between shrinking their portfolio and accepting some business at lower rates of return. If they shrink too much, they risk becoming less relevant in a contracting reinsurance market and damaging their competitive position.

Investor demand persists, while low yields in other comparable asset classes remain depressed there continues to be heightened appetite for asset classes such as reinsurance linked investments and ILS. In addition, the growth of the ILS market ensures it attracts greater attention, meaning that new investors are also likely to tap into the space.

The other positive here that we would mention, is that as the ILS asset class has matured investment managers are creating new strategies, structures and opportunities to match investors needs. As the ILS sector grows, investment managers understanding of what the right investors want increases and this is also likely to drive more capital into the sector over the coming years.

Fitch again says that it does not expect investors to exit the sector en masse should a large loss event occur, or if catastrophe spreads remain depressed. Fitch says that it:

Considers a significant portion of capital market investor funds to remain as permanent, given the nature of catastrophe risk as providing a very valuable portfolio diversification benefit and institutional investors longer term investment horizon.

We’d advise you to read this piece for a view of where the reinsurance market is heading, with the influence of ILS and capital markets a key factor in the reinsurance market’s future.

Read our other stories on Fitch’s recent reinsurance market reports:

Growth of alternative capital a credit negative for reinsurers: Fitch.

Structural change, lower margins, a deeper reinsurance convergence.

Alternative reinsurance capital to fuel M&A deal-making: Fitch.

Global reinsurance profits down, outlook still negative: Fitch.

Asian insurers look to diversify risk capital, cat bonds one option: Fitch.

You can find Fitch’s latest report via its press release here.

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