Alternative reinsurance capital is coming of age: S&P

The permanence of alternative capital in the global reinsurance sector, underlined by the growing acceptance and understanding of alternative re/insurance structures by traditional re/insurance players, shows the capital is coming of age, according to S&P.

Insurance and reinsurance ratings agency Standard and Poor’s (S&P) declares that “most, if not all, rated reinsurers have established access to third-party capital, either by establishing sidecars, issuing catastrophe bonds, forming ILS funds to manage assets for third parties, or partnering with hedge funds to write business backed by their capital.”

This is promising to hear, as a host of reinsurance industry experts, executives and analysts have stressed the importance of embracing the glut of alternative reinsurance capital that continues to enter the sector, pressuring prices and driving an intensely competitive operating environment.

Prior to alternative, or third-party reinsurance capital representing a significant portion of total, global reinsurance capacity, it currently makes up $68 billion of the $565 billion total according to Aon Benfield, market participants expressed wariness of its presence and questioned its longevity when a large loss event occurs.

However, while some in the sector might still hold reservations surrounding its permanence and impact on the traditional reinsurance model and increasingly primary lines too, after all it is still largely an untested model, the general consensus seems to now focus on how best to make use of the wealth of alternative reinsurance capital providers, from innovating in emerging markets to bolstering and diversifying existing reinsurance programmes.

“By making use of these capital sources, traditional reinsurers can maintain their relationships with clients and write more gross premium. In most cases, they also gain some non-risk-bearing fee income. Although the amount is low in terms of return on equity (ROE) for most reinsurers, it does add some income diversification,” says S&P.

One of the most notable challenges with alternative reinsurance capital, but something that is starting to materialise, relates to introducing and expanding its presence in emerging, underserved and underinsured markets, like Asia-Pacific, Latin America and China, and also developed re/insurance lines such as casualty.

A point emphasised by S&P; “However, some alternative capital providers, such as hedge funds and some insurance-linked securitization (ILS) arrangers, are seeking a way to pair capital market capacity with non-catastrophe lines of business characterized by low severity but high frequency of losses, such as short-tailed casualty or motor.”

Enabling its expansion into new, differing business lines will relieve some of the excess capacity from the property catastrophe reinsurance sector that has experienced some of the most severe market pressures, this in return should reduce some of the competition in the space, resulting in some easing on rates.

This also ties in with global efforts to increase insurance penetration levels in some of the world’s most vulnerable and poorest regions.

With an increased level of insurance take-up the demand for reinsurance will naturally rise too, signalling an opportunity for alternative reinsurance capital providers to access the emerging markets utilising mutually beneficial alternative risk transfer solutions, such as sidecars, collateralized reinsurance ventures and catastrophe bonds.

Much of third-party reinsurance capital’s rise is attributed to the catastrophe bond asset class, with issuance in 2015 already surpassing the $6 billion mark, continuing the record breaking issuance trend witnessed in 2014.

That being said collateralized reinsurance and fully-collateralized reinsurance sidecars are beginning to gain traction also, as demand for such structures spikes with the growing understanding and acceptance of investors and sponsors alike.

S&P highlights this point; “Reinsurers are also offloading some of the pricing pressure to the capital and unrated reinsurance markets by increasing their use of collateralized reinsurance (that is, reinsurance that has collateral posted against it to reduce credit risk) or retrocession protection.”

Aon Benfield, the reinsurance arm of international insurer Aon plc., reported earlier this year that alternative reinsurance capital is on track to hit $150 billion by 2018, following growth of 28% during 2014.

Furthermore, during the first-half of 2015 alternative capital growth outpaced traditional reinsurance, increasing by 6% compared to a 3% decline for traditional reinsurance, further proof that the wealth of third-party capital is starting to come of age.

So expansion for the flood of alternative capacity has been rapid, and signs point to a continuation of this trend. But as noted by XL Catlin Chief Executive Officer (CEO), Mike McGavick earlier this year, to cover the exposures the industry should really be focused on it’s “absolutely necessary” that alternative reinsurance capital is interested in the space.

It’s now widely believed that the influx of alternative capital and its permanence in the international reinsurance market has caused a structural change in the reinsurance pricing cycle, a notion highlighted by numerous industry analysts and experts in recent months.

But regardless of that being the case or not, alternative reinsurance capital is here and it’s here to stay, so firms that aren’t incorporating it within their reinsurance structures in any form currently, or have no plans to do so in the future, might risk missing out on potential geographical, income and product diversification opportunities.

Further amplifying just how important a part of the overall reinsurance landscape alternative capital has become, and that it’s expected to become even more dominant in the future, is the establishment of an insurance-linked securities (ILS) and reinsurance industry taskforce in the UK, by HM Treasury and the London Market Group (LMG). Aimed at establishing London as a hub for all types of ILS business, including catastrophe bonds, collateralised reinsurance and other third-party capital backed insurance structures.

The urge to utilise alternative capital and find ways to bring it within capital structures in the insurance and reinsurance industry is not reducing, as such the age of efficient capital could persist for some years to come as it becomes increasingly deeply embedded in traditional re/insurance business practices.