ILS to grow strongly, reinsurers to be increasingly pressured: Credit Suisse

With insurance-linked securities (ILS) and capital market participation in reinsurance expected to continue growing strongly the outlook for traditional reinsurers remains bleak, analysts at investment bank Credit Suisse explained in a research note today.

Credit Suisse’s equity analysts see the outlook as so bleak that it they have set the bank’s ratings on the world’s largest reinsurer Munich Re to “underperform” and leading competitor Hannover Re downgraded to “neutral”, saying that the competition posed by ILS, such as catastrophe bonds and collateralized reinsurance, would be felt by the reinsurance industry for a long time.

The threat posed by insurance-linked securities (ILS) will not just be temporary, analyst Adam McInally wrote, rather this is a threat to the reinsurance industry with a long-horizon, that could play out over many years to come as the industry evolves.

Alternatives to traditional reinsurance will impact on the established reinsurers profits, the research note explains, with the securitisation of insurance risks through ILS and catastrophe bonds forecast to have a long-term negative impact on the amount of reinsurance premiums available to traditional markets.

Both of the German reinsurers saw their share prices drop as a result of the negative outlook. With reinsurance business conducted with ILS and using third-party capital expected to grow strongly, traditional market participants may find the sustainability of their profits hard to maintain and the stock markets may be too optimistic in their profit forecasts for traditional reinsurers.

Thanks to the introduction and growth of ILS and catastrophe bonds those seeking reinsurance protection have another option to leverage the capital markets interest in catastrophe and other risks. As a result reinsurers are suffering, the report suggests, and this suffering is not expected to stop any time soon.

The traditional reinsurance business is set to remain under pressure, with increasing levels of competition, as well as increasing numbers of new hybrid business models seeking to further disrupt the status quo.

It should be noted that Munich Re has greatly increased the role that third-party capital plays within its own underwriting, upsizing its use of collateralized sidecars significantly for 2015, as it seeks to realise some benefits through sharing risks with lower-cost capital.

Meanwhile Hannover Re has a leading role as a fronting market and has also begun to facilitate the issuance of private catastrophe bond or ILS transactions.

So both of these reinsurers are already expanding their use of the capital markets in response to the increased pressure.

With that in mind thoughts have to turn to the smaller reinsurers, once again. If the Credit Suisse analysts see the largest reinsurers in the world as under increasing pressure and with optimistic targets, then how can the smaller players hope to compete if the pressures continue to increase in years to come?

What seems really important right now is for reinsurers to have a strategy in place that will allow them to make as much use of third-party capital, both in their underwriting in order to be expansive and for their retro needs to save costs.

Denying that the capital markets have a future in reinsurance seems a risky strategy, as does relying on your balance-sheet alone unless you can significantly lower your cost-of-capital.

If the disruptive trends created by lower-cost, more efficient ILS capital continue as forecast, reinsurers are going to have to get on-board or risk missing the boat entirely.