Marked increase in flow of capital into non-traditional vehicles and catastrophe bonds

Reinsurance broker Willis Re, the reinsurance arm of Willis Group Holdings, has published its 1st View mid-year renewals report which looks at the 1st June and 1st July reinsurance renewal periods and comments on findings on rate movements, availability of coverage and conditions in both the traditional reinsurance market and non-traditional capital markets backed convergence reinsurance segments. The report suggests that capacity in the reinsurance market is plentiful and that the reinsurance market is not hardening.

The report which is titled ‘Looks can be Deceiving’, an appropriate title given the contents, finds that despite forecasts for reinsurance rate increases, there is plentiful capacity available in the market which has reduced pressure on many lines of business. By taking a targeted underwriting approach to manage, analyze and, in some cases, de-risk their portfolios, reinsurers have been rewarded with differential pricing, the report finds. The approach has naturally been welcomed by cedents, perhaps offering them better value, but does not support a generalized market hardening says Willis Re.

“The reinsurance market is stable and orderly, but the reality is that it is not hardening,” says Peter Hearn, Chairman of Willis Re. “In fact, some buyers with loss-free programs, even in areas of peak exposure, have managed to obtain risk-adjusted rate reductions at the June 1 and July 1 renewals.”

“The impact of changes to vendor catastrophe models is becoming increasingly muted as the industry becomes more sophisticated,” Hearn added. “Companies and Regulators realise that they cannot be too reliant on one model, and are instead blending models to show realistic possible outcomes.”

Interestingly Hearn cites the impact of external economic factors as something which could eventually result in a hardening market. He said; “Curiously, despite the fact this scenario is well known and widely discussed in industry circles, pricing on longer tail classes remains soft despite these warning signs to reinsurers’ balance sheets. The eventual increase in interest rates, coupled with an increase in inflation, could potentially trigger a hard market ahead of significant loss events.”

The report mentions the continuing inflow of capital market capacity into the reinsurance sector, saying that Willis Re have noticed a marked increase in the flow of capital into non-traditional reinsurance vehicles. Hedge fund investors are increasingly being joined by longer term investors such as pension funds who are attracted to the returns offered and non-correlated nature of reinsurance-linked investments. This capital and capacity is not just flowing into catastrophe bonds but also into sidecar capacity for existing reinsurers. The report notes that sidecar capacity works well for more capital-intensive areas of reinsurance such as Florida catastrophe reinsurance and retrocessional property lines.

While this new capital coming into reinsurance is clearly welcomed and has helped to stabilise rates, so going some way to helping stave off a hard market, there are concerns about how sticky it will be, says Willis Re in the report. Typically this investor and capital market sourced capacity has been fickle and followed rising rates and periods of high catastrophe losses. Much of the capital is untested and capital from single source investors could be particularly volatile, where as funds and sidecars involving multiple investors could be less volatile. We wrote about the potential stickiness of this type of capital recently here.

The report also highlights that these inflows of capital are making things tougher for traditional reinsurers at a time when their investment returns are weaker. The ample capacity created by the capital inflows into non-traditional reinsurance vehicles and cat bonds is keeping pressure off rates and making investing in traditional structures seem less appealing at the moment. On this Peter Hearn said; “Against this demanding background, traditional reinsurers face the challenge of earning an acceptable return on their capital. However, despite their own difficulties, most reinsurers remain focused on providing their clients with differentiated support.”

Specifically on the capital markets the report says that investors continue to grow their assets under management, helped by accelerating catastrophe bond issuance which Willis Re projects will result in 2012 issuance of $5.5 billion to $6 billion. They project that outstanding catastrophe bond capacity will reach $15 billion to $15.5 billion at the end of the year.

On the second quarters cat bond issuance, Willis Re have seen a rising risk spread trend for peak risks reverse at the end of the quarter. This was evident in some of the transactions which completed in May/June as spreads became more palatable for some issuers. Indemnity trigger structures were all the rage in Q2 2012, five of the eight transactions we recorded in Q2 used indemnity triggers with two a form of modelled loss index and the final deal an industry loss index. You can see the details of triggers used in every cat bond deal in our Deal Directory.

On the property-catastrophe and non-marine retrocession markets Willis Re saw sufficient traditional capacity and ample collateralized capacity with new and renewed sidecars as well as a number of new funds emerging. Reinsurers continued to want to limit scope of retro covers to named territories and perils, likely caused by the heavy catastrophe loss toll of 2011 and a desire to underwrite more conservatively. The lack of catastrophe losses so far in 2012 is allowing buyers to look at their appetites for retaining more risk, another natural occurrence in the wake of a period of high losses and moving into a period of lower loss occurrence.

In general, Willis Re says that retrocession price increases have held to levels seen at the start of the year although some programs exposed to Thai flood claims continue to see large price increases in line with their exposure. The industry loss warranty (ILW) market was sluggish in late May and early June however plentiful capacity has led to some sizeable price reductions and an increase in activity as we enter the U.S. hurricane season according to the report.

The report also contains commentary on specific lines of reinsurance business, where Willis Re have seen rate movements and their outlook for the sector. You can access the full report in PDF format here.