A new report from rating agency A.M. Best looks at the fortunes of the U.S. and Bermuda reinsurance market and concludes that reinsurers are currently stuck in the middle of two converging forces, abundant capital and rising retentions.
The word convergence is often used to explain the merging of the reinsurance and capital markets, or capital and risk, as alternative risk transfer structures and capital from third-party, institutional investor sources disrupt the traditional reinsurance marketplace. In reality, two factors are converging to increase the pressure on some reinsurers, capital and retentions.
The traditional reinsurance market remains highly capitalised, after some profitable years and a lack of major losses recently. At the same time alternative capital continues to flow into the reinsurance space, largely from institutional and capital markets investors, seeking low correlated and diversified investment yields particularly from property catastrophe risk.
At the same time as capital in the sector has been increasing, primary insurers have been increasing the amount of risk they are willing to hold on their balance sheets, resulting in greater retention of risk and less growth in available opportunities for reinsurers. For some reinsurers these two factors have themselves converged to increase pressure on traditional business models.
In its report, titled Stuck In the Middle: Reinsurers Face Converging Capital, Rising Retentions, A.M. Best notes that it is the strength of the U.S. and Bermuda reinsurance market which has contributed to the high levels of capital among traditional players. A focus on prudent underwriting and pricing fundamentals have assisted with increasing capital in the space.
Despite diminishing underwriting and investment opportunities, reinsurers management have held the line with respect to pricing, said A.M. Best, expecting to be paid adequately for the risks underwritten. Sensible use of redundant reserves, as well as a subtle shift in investments strategies, have also allowed reinsurers to augment earnings at what has been a difficult time the report says.
Nonetheless, A.M. Best says, there are seismic shifts occurring in the reinsurance industry, created by alternative and third-party capital entering the space. The U.S. and Bermuda reinsurance markets are at the epicentre of this shift, due to their strong position in the U.S. property catastrophe reinsurance market, where the greatest competition is being seen.
Abundant capital, both from the well-stocked traditional reinsurer balance-sheets as well as the third-party capital from pension funds and other investors, as well as increased primary insurer risk retention are converging to build the pressure on reinsurers.
A.M. Best’s report says; “With third-party capital taking the higher layer of exposures and primary companies increasing retentions, reinsurers appear to be stuck in the middle. Many industry observers agree that the reinsurance market may be at an inflection point.”
The report suggests that the increased inflows of third-party funds from the capital markets could be a game-changer for the reinsurance industry. A.M. Best notes that capital convergence in the reinsurance sector is not necessarily an ‘ immediate death knell’ for the traditional reinsurer business model.
However, momentum has increased in terms of interest (we would add awareness of the space) and the pace of entry of third-party capital. A.M. Best notes that this capital pool is vast, becoming more comfortable with reinsurance risks and is very likely to increase its participation in the space in some manner.
The report highlights the two great unknowns with respect to reinsurance convergence; how much capital will enter the space and how long its commitment will be. Most people’s opinion now is that as third-party capital gets ever more comfortable with reinsurance, and reinsurance becomes more like an asset class, the amount of capital will increase.
Where the equilibrium between traditional and third-party capital is found will have a lot of bearing on how the market changes, notes Best. This is a very salient point. Currently capital is driving change in the market and looks set to find its own point of equilibrium. But, perhaps by launching their own third-party capital management units reinsurers are seeking to force the point of equilibrium to be found in their favour?
The report notes that there are risks inherent to such a period of change in market structure. Noting a decline in underwriting standards, a diminishing of the relationship aspect of the reinsurance market and also the potential for disputes or litigation over losses which are unexpected or where contract wording is unclear.
The report notes that the traditional reinsurance firm will need to adapt and innovate in response to the influx of third-party capital, perhaps being more creative than simply beginning to manage some third-party capital itself. Reinsurers will have to become more creative, look to new business opportunities, lines of business and products, or alternatively dig their heels in and risk being disrupted by the new, leaner collateralized competition.
A.M. Best notes that reinsurance companies, with their strong underwriting and analytical capabilities, are likely best positioned to provide innovative products for complex risks and to help to narrow gaps between economic and insured losses. Interestingly this is also the areas that a number of dedicated ILS players are expressing a desire to grow the market into, which perhaps may put traditional and alternative on yet another collision course.
The report from A.M. Best is thought-provoking and once again raises a number of concerns for traditional reinsurers. However the analysts who wrote the report say they expect U.S. and Bermuda reinsurers to post solid results for the year, helped by a lack of large losses.
The real shake-out of the reinsurance market has not yet occurred, it may not even occur in 2014, the trends are still developing and change, while picking up pace, may still be some way off. The upcoming January renewals should give a good picture of the rate environment and whether third-party capital has made further inroads into the traditional reinsurers world, but we may need to see some large losses and a number of renewal seasons to fully appreciate just how much of an appetite the capital markets investors have for involvement in the reinsurance space.
You can access the full report from A.M. Best here.