A.M. Best highlights potential barriers to growth of alternative capital

by Artemis on April 27, 2016

Ratings agency A.M. Best has noted that the continued growth of alternative reinsurance capacity in the global risk transfer landscape could slow somewhat in the future, citing the potential of future losses, a focus on catastrophe insurance and the rise of defined contribution (DC) pension funds.

Alternative, or third-party reinsurance capital continued its strong growth trend in 2015, with reinsurance broker Aon Benfield noting that non-traditional reinsurance capacity increased its share of the overall reinsurance market to 12%, or $72 billion in 2015.

“Despite the scale of wider capital markets, A.M. Best sees reasons to expect at least some part of alternative capital in catastrophe reinsurance market to withdraw in response to large losses,” said A.M. Best.

The global reinsurance sector continues to experience a benign loss environment, underlined by the absence of a landfalling hurricane in Florida for more than a decade.

When significant losses occur in any sector it’s typical that some capacity providers and their capital exits the space, so it’s not too surprising that A.M. Best feels some of the alternative capital will follow this trend.

“For example, the market has developed to include participants with varying degrees of commitment, providers of collateralised reinsurance would likely find pledged collateral frozen, and those who have invested in part as a response to low returns elsewhere may be uncomfortable with negative returns,” explained A.M. Best.

The ratings agency highlights an interesting point, but it’s worth stressing that the increased sophistication and maturity of insurance-linked securities (ILS) investors, which mainly consists of pension funds, only allocate a small percentage of their investment portfolio to the asset class, which could also mitigate the amount of capacity that leaves the sector post-event.

Furthermore, it’s widely viewed among the re/insurance and ILS space that there’s an abundance of alternative capital waiting on the side-lines, looking to enter the space when rates improve or the next large event takes place, which it undoubtedly will. And ILS managers are actively looking at ways to mitigate the risk of collateral lock-up.

The ongoing trend of low catastrophe losses is happening at the same time as the continued influx of capacity from both alternative and traditional reinsurance sources, contributing to a highly competitive landscape that has resulted in persistent rate declines across the majority of business lines.

The steepest rate declines have occurred in the property catastrophe space as for the most part this is where the wealth of alternative reinsurance capital has focused, owing to its ease of entry and well-understood/modelled exposures.

It’s possible this is part of the reason the growth of alternative reinsurance capacity could slow in the coming months, should rates continue to decline below desirable returns as competition for a seemingly shrinking market share intensifies.

However, should the willing and able volume of capital market investor-backed capacity begin to have a more influential impact on business lines outside of the property cat space, like casualty for example, or in emerging risk locations and perils, then any reduction from the property catastrophe arena could potentially be offset.

“In addition there are wider considerations which might lead to an expectation that the influence of alternative capital on catastrophe insurance risk will have its own limits,” said the ratings agency.

“Pension fund investment has become important to the growth of alternative capital in insurance markets but it is essentially a feature of defined benefit (DB) pension funds, where pension fund appointees can, subject to fiduciary constraints, have wide investment authority,” continued A.M. Best.

The ratings organisation believes that the rise of DC pension funds, which it states are increasingly displacing DB pension funds, “might be expected to act over the longer term as a brake on the scope for growth of alternative insurance capital.”

This is because A.M. Best feels that it’s a long way in the future before DC pension fund members would select insurance risk investment via alternative capital vehicles, given the sophisticated and largely non-retail nature of the ILS market.

It’s another interesting point the ratings agency raises, but it’s important to remember that the range of DB pension funds that currently invest in the ILS space, making up a large proportion of its overall size, will be required to exist for many years to come owing to the nature of their business and fiduciary duty to future pensioners.

It’s also important to note, that as ILS becomes an increasingly accepted asset class and access to it broadens, through multi-asset class investment funds, mutual funds, UCITS and the like, it is becoming increasingly accessible to defined contribution pension funds and indeed even those managing their own pension investments.

But, as A.M. Best explains there are potential barriers and influences that could dampen the growth of alternative reinsurance capital in the coming months and further into the future, of which it is important to remain aware.

But it’s also important to remember that ILS capacity and its providers are becoming ever more sophisticated and mature, along with the features and structures within the sector.

As ILS and insurance risk becomes an increasingly established asset class, it suggests that the capital markets will play an increasingly important role in the global risk transfer landscape in the years ahead, likely overcoming any potential growth headwinds.

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