Alternative capital & reinsurers to be increasingly interdependent: Moody’s

Alternative reinsurance capital and traditional reinsurers are set to become increasingly interdependent, as the two forms of capacity identify synergies and better ways to work together, while reinsurers get more adept at matching risks with the most appropriate form of capital, according to Moody’s.

Rating agency Moody’s has provided an update to its outlook for the global reinsurance industry in 2018, saying that it expects profitability to improve, as measured by return on capital, thanks to price increases following the catastrophes of 2017 and the slight reduction in reinsurer capital as a result.

At the same time, Moody’s says that it expects the capital markets will become increasingly influential in reinsurance as well, forecasting that, “Alternative capital will account for an increasing share of reinsurance capacity, both directly to cedants, and as reinsurers limit their net exposure by taking more third-party capital into their own ILS funds, or buying more retrocession.”

While profits are set to improve for reinsurers, alternative capital is set to exert its influence there, and will “dampen price increases relative to historical post-event hardening cycles,” Moody’s says, adding that while improvement is expected, “we do not expect them to return to pre-2013 levels.”

But despite the influence alternative capital and insurance-linked securities (ILS) have and will continue to exert on the levels of profit achievable by reinsurers, they are still set to use more of it and let the ILS business model become increasingly interwoven within their traditional reinsurance strategies.

But price effects aside, the use of alternative capital is set to continue to increase and Moody’s forecasts a “growing interdependence” between reinsurers and alternative capital, as convergence continues apace.

“Over the past three years, reinsurers have ceded an increasing amount of risk to alternative capital providers, primarily in the form of collateralised reinsurance, to lower their own blended cost of capital and enable competition with alternative capital for profitable property-catastrophe risk,” Moody’s explains.

The interdependence of alternative and traditional reinsurance models has gone through a number of phases, a journey as the two strategies have become increasingly intertwined.

From the use of the capital markets as a pure hedging tool, a source of capacity able to bear the very large peak catastrophe perils.

To leveraging the capital markets in order to compete with the capital markets, a phase that saw some reinsurers cannibalising their own results.

To establishing third-party investor backed funds and ILS vehicles, trying to earn fee income from them.

To a harmonised approach, where alternative capital takes on the risks that a reinsurers own balance-sheet can no longer support, letting the reinsurer earn some income for its risk expertise without needing to put its capacity to work.

Most reinsurers are somewhere along this journey at the moment, some further than others, some still struggling with how to embrace alternative capital in such a way that it enhances their business, rather than shifting profits away from their shareholders.

Moody’s notes that the transition from traditional reinsurers to multi-balance sheet managers of risk and capital has accelerated in 2018, as reinsurers sought to access the appetite of capital market investors to participate more in catastrophe reinsurance after the major losses of 2017.

“A number of (re)insurers have upsized their alternative capital vehicles, including insurance-linked securities (ILS) funds and sidecars, during the first few weeks of 2018, accelerating a shift in revenue mix towards fee income from managing third-party capital,” the rating agency said.

The shift in revenue mix needs to be carefully controlled by reinsurers, but those successful in becoming more interdependent with alternative capital investors stand to be able to tap into the largest and most liquid source of risk capital available.

If put to work in the right way, with the goal of monetising their origination reach, intellectual capital and risk knowledge, reinsurers stand to benefit greatly from a more efficient and lower-cost source of capacity that can take on the risks that their own balance-sheet equity no longer supports as well (or profitably) as it used to.

“We expect this trend to continue as (re)insurers become more sophisticated in matching risk with the appropriate form of capital,” Moody’s said, also highlighting another key driver for this trend saying that alternative capital can help reinsurers to, “grow the top-line while keeping net exposure in check.”

Moody’s sees reinsurance firms as likely to leverage alternative capital to “flex their underwriting capacity up or down based on demand and pricing” but notes that this comes with its own risks, as the capacity from third-party investors could be less permanent than their on-balance-sheet equity.

The industry landscape will adjust, as reinsurers become increasingly interdependent with alternative capital, Moody’s believes, saying that it expects the market will have fewer players in years to come.

“We expect a continued shift towards a smaller number of larger reinsurance groups that effectively deploy their own balance sheet capital alongside third-party capital against the risks they source and underwrite,” the Moody’s analysts explained.

The challenge is to achieve interdependence while still meeting the return expectations of the capital market investors and ensuring reinsurance firms are making a sustainable level of profits, across their diversified businesses.

Fail to do either of those and the partnerships are likely to soon end. In the first case as investors vote with their feet and find better partners (or more direct ways) to do business with, or in the second case as reinsurers find they can’t make that business model work for themselves.

How many options that leaves for reinsurers in years to come remains to be seen, but it’s unlikely there will be a plethora of them.