The reinsurance market – A new structural reality: A.M. Best

by Artemis on September 2, 2015

The reinsurance market is “operating in a new reality of abundant capacity from traditional and alternative sources” according to A.M. Best. Historically change in the reinsurance market has been said to be cyclical, but the current wave of change is thought structural in nature.

A.M. Best’s latest report on the global reinsurance market is its regular segment report timed to be published just before the market meets in Monte Carlo for the Rendez-vous. The report hits on many key themes that we have been covering over the last few years at Artemis, which all point to a change in the reinsurance market that may mean it never looks quite the same again.

The rating agency explains that the “rapid pace of change within the reinsurance sector over the past few years has given way to the permutations of a “new reality” that is being shaped by abundant capacity from traditional and alternative sources.”

Of course it’s not just capacity and the influence of the capital markets and growing insurance-linked securities (ILS) activity that is impacting reinsurance, also responsible are lower interest rates, intense competition, changing buying habits, reduced demand and an evolution in the way insurers consider their protection.

All of these factors alongside a relatively catastrophe loss free few years have helped to soften reinsurance rates and are ultimately resulting in thinner margins being available on reinsurance underwriting, making it more difficult for reinsurers to sustain their returns on equity.

But this is not just part of the reinsurance cycle, the typical ebb and flow of capacity and pricing that historically occurred around major loss events or financial influences, this is a “new reality” created by structural changes in the way risk is considered, addressed, structured, financed and transferred.

“The new reality for the reinsurance market looks to be more of an industry where returns are less impressive and underwriting will have to become a larger contributor to profits and returns,” commented A.M. Best Vice President Robert DeRose. “This will lead to more conservative risk selection, more diversification of product offerings, a wider geographic reach and conservative loss picks.”

As a result of the assessment update, A.M. Best is maintaining its negative outlook for the global reinsurance sector, citing “significant ongoing market challenges that will hinder the potential for positive rating actions over time and may translate into negative rating pressures.”

Clearly one of the main influences on the reinsurance market in recent years has been the growth of ILS and the inflow of more efficient capital from third-party sources. The growth of catastrophe bonds and ILS, then the appetite for reinsurance risk that drove the collateralized reinsurance wave and finally the acceptance of catastrophe risk and reinsurance as an asset class, are key reasons that the market has been changing.

However, A.M. Best warns that cheaper capital alone will not define the winners as the structure change in reinsurance shakes out.

“Those deemed winners at the end of the day must be able to walk away from bad business, have the capital and expertise to write new, more complex lines of business and provide the products and services that clients want in a global economy,” the rating agency explains.

One key factor for success, both for traditional and alternative players, is being able to manage the inflow of third-party capital to their own benefit.

“Companies that have created expertise in managing third-party capital to their own advantage,” will stand greater chance of effectively navigating the structural change, the rating agency notes.

It’s a point that has been repeatedly made in the last few years, the need for the traditional reinsurer, or indeed insurer, to find the best way to welcome third-party capital within its overall capital structure.

It’s essential to do this without cannibalising existing revenues, without creating the potential for conflicts of interest and to ensure that incremental revenues are introduced, with the help of alternative or third-party capital, or for it to generate savings such as with internal reinsurance arrangements or sidecars.

In fact, A.M. Best notes that for some traditional players the combination of existing underwriting prowess “the ability to take advantage of the new “cheaper” capital coming into the market by investors that may not have the reinsurance and underwriting expertise that most of these companies possess could actually lead to significant success.”

So far there are only a few traditional players that have truly embraced alternative capital and brought it within their business structures. For many others, the first attempts to manage third-party capital have been made, but largely as a way to generate incremental fees.

The secret, if indeed it actually is one, is to find a way to use alternative capital to target business lines that no longer provide the returns that the balance sheet requires, or to expand into new lines and types of risk.

Purely managing third-party capital while sharing a portion of the existing risks underwritten with investors is not a long-term strategy. It can be a building block on the way to more meaningful introduction of new capital into the business, but it must be managed carefully to ensure value is still being created for the traditional company, as well as the third-party investors.

A.M. Best sees this embracing of new capital sources as a sign that reinsurance firms are adapting to become the “gatekeepers of insurance risk” responsible for managing the risk sharing and alignment with third-party capital providers for both property and non-property lines.

As we said above, there are a few firms heading in this direction currently, who really could position themselves as “gatekeepers” providing the service of marshaling risk to the capital with the correct risk appetite. But it is by no means widespread yet.

There is still a traditional view of seeing alternative capital as a sidecar to pass off a portion of all your risks to, a source of cheap retrocession or a flexible capital source that will be downsized at the first sign that the risk should be taken back internally.

With capital market investors becoming increasingly educated regarding ILS and reinsurance linked investing, the larger investors are looking for something more permanent, longer-term and with greater alignment of interests.

Those traditional companies who get this right and find an equilibrium whereby alternative capital finds its place within their business model, stand the best chances of using third-party capital effectively and for profit, rather than risk reducing their own returns due to the use of it.

A.M. Best warns that times are not going to be easy for reinsurance firms, whether we are seeing a floor in pricing emerge or not. “Not everyone will win in the end,” the rating agency says.

Those companies that have been “conservative in underwriting and in reserving”, while underwriting and developing a book of business that will “remain relevant for today’s market”, that is nimble and can shift “in and out of lines of business depending on market conditions”, and effectively manage third-party capital are the ones expected to have the best future, the rating agency explains.

A.M. Best notes the importance of being able to “participate in the new era of consolidation without being left out of the game.”

We would add to this, that it is not just being able to participate in the wave of consolidation that is vital for companies as they navigate the structurally evolving reinsurance market, as it is yet to be proven that scale is everything.

It’s also vital to be able to embrace innovation, adapt rapidly to change, leverage the latest technology, become masterful at product design and development, prove agnostic to sources of capital and know how to extract real value from using them, while still maintaining discipline and underwriting a book of business that performs.

One thing is certain, the reinsurance market has changed and the reinsurance business model is now changing to adapt to this new market reality.

Structural change is always difficult for incumbents, but also provides opportunities to get ahead of the pack, in order to ride out the wave of change more profitably than the rest of the market. We’ve now reached the stage of market development where some companies are beginning to show signs of leading.

It’s those who are left behind, or have had their heads buried in the sand, who may struggle going forwards.

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