Underwriting a focus as alternative reinsurance capital challenges mount

Reinsurance industry CEO’s and senior executives meeting last week at the PwC and Standard & Poor’s Ratings Services 2013 Bermuda (Re)insurance Conference discussed the need to increase their focus on underwriting to offset challenges, including alternative reinsurance capital.

The reinsurance industry faces headwinds, according to Standard & Poor’s, having begun 2013 with record levels of capital after strong earnings in 2012, this trend continued through the year. Catastrophe losses remain below, or at, average levels, while increasing interest in reinsurance and insurance-linked securities from institutional and capital markets investors has also helped to boost sector capitalisation even further.

This increased supply of risk capital, coupled with sluggish demand for reinsurance protection from developed markets and highly capitalised primary insurers, has put pressure on pricing and the reinsurers top line. Add to this the expected drag of a low-interest rate environment, affecting investment returns and reserve releases, and maintaining strong performance may be a challenge for reinsurers, according to executives at the event.

Dennis Sugrue, sector credit analyst and director at Standard & Poor’s, said; “The machine isn’t as well-oiled as you might think. Reserve releases aren’t as sustainable as in the past. Contribution of investment income is diminishing in a low-interest-rate environment. Competitive forces are making it harder to grow top-line profitably; all of these forces are challenging returns. We think interest rate risk is most pervasive for reinsurers.”

Underwriting performance is seen as increasingly important, under the current reinsurance market conditions. With income from investments at risk from interest rates, and competition from alternative reinsurance capital growing, reinsurers are focusing (or should be) on building the highest quality portfolios of risk that they can in the search for positive underwriting returns.

“We very much focus on underwriting first, second, and third,” stated Simon Rich, senior VP and global treasurer at XL Group plc.

Regulation is another key issue that plays on the mind of reinsurers in the current market environment. The costs and overhead associated with preparing for regulatory changes such as Solvency II is a growing concern in a competitive and declining rate environment.

“Cost of regulation is immense,” said Mr. Rich. “Delays in implementing Solvency II don’t help; it just drags it out. The scale of regulation is hugely broader than it was before. Solvency II is questioning whole business models, strategy” and the “degree of compliance in that area is not yet established.”

Expense ratios is another topic of conversation in the market, as reinsurers struggle to come to terms with more efficient capital from ILS players with leaner business models and much smaller teams. Turning to technology is one area that executives discussed, raising issues such as less business travel and more video conferencing as areas they were exploring.

Technological advancement in terms of how reinsurance business is undertaken is certain to bring benefits to large, expense heavy, reinsurers and opportunities abound for reinsurance savvy software development firms at this time.

Jay Bullock, EVP and CFO at Argo Group, commented; “To solve larger issues, technology is really the answer. It’s a different business model, so technology’s absolutely critical. It enables us to write more business; be more efficient.”

Executives at the event discussed issues such as the potential for mergers and acquisitions, or meaningful consolidation, to be one of the outcomes of the highly competitive marketplace. Reinsurers said they see opportunity in some specialty lines, and some run way ahead of them, but that opportunities for M&A may come up in the next few years.

The convergence market, where the world’s of reinsurance underwriting and capital market investors collide, was a hot topic which received significant attention at the event. Some saw its increasing participation in the market as highly positive, for both buyers and sellers of reinsurance protection alike, while others felt it added increased competition at a time when the traditional reinsurance business model is under pressure.

Bryon Ehrhart, CEO of Aon Benfield Americas, said the entry of alternative capital “has had a positive impact” in that it’s given his company the opportunity to present its clients with additional risk-transfer options–a situation, he noted, that has “improved greatly in the past 18 months.”

Kean Driscoll, CEO of Validus Reinsurance Ltd., stated that third-party capital has become an “important component” in his company’s overall strategy, allowing Validus to provide “diversity of capital.” At the same time, Driscoll believes that alternative reinsurance capital and ILS is not a panacea for all of an insurers risk transfer needs, saying that the “traditional reinsurance product is ultimately more compelling to the vast majority of our client base.”

Kevin Kelley, CEO of Ironshore Inc. said that he felt it no surprise alternative and third-party capital entered the reinsurance market, as the barriers to entry are considerably lower than in primary insurance. Kelley said; “This new capital will ultimately get a return or go elsewhere to get that return. It’s clearly the ebb and flow of what we’ve seen on the global scene.”

Erhart reiterated Aon Benfield’s opinion that the amount of alternative capital in the reinsurance market is set to grow strongly. “It’s nowhere near a plateau,” Ehrhart said, adding that he expects another $100 billion in alternative capital to enter the market during the next five years. He qualified that statement by adding that it’s a question of how it’s managed.

On the impact on pricing, Validus’ Driscoll said that there’s; “Clearly a supply-demand imbalance, manifested in pricing here [in Bermuda] and the U.S.” However, he said that while pricing has declined the margins on property catastrophe risk remains attractive. Driscoll said that the challenge now lies in companies being able to scale to meet with demand and to be able to effectively distribute risk capital. “Price will be price; it’s simple supply and demand.”

Driscoll reiterated Validus’ opinion that the traditional reinsurance, ILS and alternative reinsurance capital market is ready to take on more terrorism risk. He said; “The industry hasn’t served itself well before Congress, saying that traditional terrorism cannot be priced. We disagree with that. As an industry, we committed substantial resources on how to price the frequency of traditional terrorism. We’re of the view that the market could bear more traditional terrorism risk.” Driscoll said that TRIA should be limited to risks which are unquantifiable, such as nuclear, biological and cyber terrorism.

Driscoll also pointed to emerging markets as opportunities for growth, both for traditional reinsurance and ILS. “Parts of China where earthquakes and typhoons are prevalent can present challenges,” he said. “In the long term, there are some really compelling opportunities there. Our challenge is to educate customers and focus on data quality.”

This year, 2013, has seen considerable discussion on where the reinsurance market is going next, triggered by difficult economic conditions, over-capitalisation and the growing interest from capital markets in reinsurance as an asset class. This discussion is set to rumble on and it will be interesting to see how the tone of conversation changes post January renewals after we see which direction the trajectory of reinsurance rates is headed.

Read our other article on this event: Proactive innovation through ILS is driving change in reinsurance.