Might not be for Buffett, but ILS shows reinsurance is a desirable asset class

by Artemis on June 17, 2016

Analysts at Bernstein have highlighted continued pressures in the global reinsurance marketplace, noting recent divestment in the sector by Warren Buffett. However, as evidenced by the continued influx of ILS capacity in the reinsurance space, just because it’s not right for Buffett doesn’t mean it’s not a desirable asset.

Throughout 2015 there was much discussion about Warren Buffett, Berkshire Hathaway’s Sage of Omaha, and his views on the reinsurance landscape and its outlook for the future.

Buffett was seen to pull back on underwriting in the highly competitive property catastrophe space and in general, diminished his overall exposure to declining reinsurance pricing by reducing investment stakes in reinsurers like Munich Re.

Bernstein analysts note that in April, Buffett stressed that reinsurance would most likely remain “unattractive, if not terrible for a considerable period,” and while this isn’t the first time in recent memory Buffett has expressed negative views on the space, Bernstein underlines that it’s important he backed this view with divestments in the sector.

Undoubtedly, rates in the global reinsurance sector are continuing to decline and the steepest reductions continue to be witnessed in the highly competitive property catastrophe space. Additionally, the pressures coming on traditional re/insurers to innovate, adapt their business models and compete with new insurtech entrants, perhaps make the sector less attractive for an investor like Warren.

But just because it’s not right for Buffett’s approach and business model, doesn’t mean it’s not a good investment for others.

The insurance-linked securities (ILS) space continues to grow and broaden its reach, claiming an increasing share of the overall reinsurance market pie, a trend that continues. To date, owing to ease of entry and better understood/modelled risks, alternative reinsurance capital has largely focused on the property cat space.

But increasingly investors are accessing a broader range of risks, looking to access risk more directly through relationships with primary fronting companies and working on ways to enter into markets such as Lloyd’s.

This innovation and continued expansion of the overall remit of ILS all supports the notion that for some institutional investors, companies and certain strategies, or business models operating in the current reinsurance market climate, reinsurance is still an attractive investment.

Obviously returns aren’t what they were a few years back owing to the softening market landscape, but for ILS funds, managers and importantly the wealth of end-investors in the sector that continue to invest in reinsurance-linked business, there’s clearly scope to persist and the benefits of the ILS asset class (low correlation, diversification, relatively steady returns) outweigh any decline in rates.

Discussing the cyclical nature of reinsurance, Bernstein underlined what other market observers have said previously. Perhaps owing to the wealth of alternative and traditional reinsurance capital, both in the space and waiting on the sidelines to come in (enabled by ease of entry), it’s possible “today’s market is not a cyclical low, but a new normal of lower returns.”

It’s also important to highlight a point we’ve discussed previously at Artemis, that while Buffett continues to divest direct reinsurance business, as seen with his pull back in both Munich Re and Swiss Re, Berkshire Hathaway continues to supply large volumes of reinsurance capital via both the syndicated market and other quota share arrangements.

It’s clear that Buffett is wary of the persistent softening reinsurance landscape and reduced rates, and has therefore pulled back on direct investments through traditional syndicated, renewal driven, reinsurance business. Buffett himself is adapting his strategy in insurance and reinsurance to manage the market’s ebb and flow.

And this is the case for many in the sector in recent times, including ILS managers and funds that are increasingly looking to get closer to the original source of risk, essentially disrupting the value chain in an effort to increase returns, reduce intermediary costs and avoid renewal cycle competition.

Buffett’s strategy clearly continues to work for Berkshire Hathaway, the float keeps on increasing, and as such it’s not surprising that analysts discuss his approach and market movements when viewing the reinsurance market landscape.

But again, just because it’s not right for Buffett in the current climate (according to the mainstream financial press), doesn’t mean it isn’t a good alternative investment for the needs and strategies of other investors, as evidenced by the persistent influx, expansion and innovation of the ILS capital market.

Large investors now have a liking for ILS and are expected to stick around as a result, providing an opportunity for insurers, reinsurers, ILS fund managers and investors to figure out the best ways to put this capital to work for the benefits of their own businesses.

And as the attraction becomes more related to insurance risk, or risk alone, as an asset class, with the ILS sector expanding its remit and moving further towards the sources of the underlying asset, we can expect growth to continue.

What form or structure that growth manifests as is the unanswerable question, things may look very different, in the insurance, reinsurance and risk transfer space, in just a few years as the pace of change perhaps even accelerates.

The way investor capital accesses risk could change dramatically in years to come, but the attraction to investing in risk and insurance looks unlikely to diminish any time soon.

Also read:

The four commandments of reinsurance, according to Warren Buffett.

IAG reports NZ quake deterioration, bulks up Buffett reinsurance.

Warren Buffett continues to dial back on reinsurance.

Berkshire Hathaway demonstrates flexibility of Buffett model.

Berkshire Hathaway invests in IAG, gets quota share reinsurance deal.

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