Alternative capital a “key risk” for traditional reinsurance: EIOPA

For the traditional reinsurance market the competition from alternative sources of capital, such as third-party institutional investors and insurance-linked securities (ILS) funds, is a “key risk”, according to EIOPA.

The EU insurance and reinsurance industry watchdog, the European Insurance and Occupational Pensions Authority (EIOPA), refers to the threat that the growth of ILS and alternative capital poses to traditional reinsurers in its latest Financial Stability report.

The report discusses the difficult macroeconomic environment, which is pressuring insurance, reinsurance and pension business models. The low-yield investment environment, threats created by quantitative easing (QE), as well as credit risks are all cited as threats to all sectors, while alternative capital is cited as a key risk to reinsurance business models.

Gabriel Bernardino, Chairman of EIOPA, said; “Today’s macroeconomic reality is creating severe challenges for certain insurance and pension fund business models. In this environment it is fundamental that supervisors monitor the situation very closely and challenge the industry on the sustainability of their business models.”

The report explains that in insurance and reinsurance, the “returns and profitability of products remain under strong pressure with a potential negative impact on solvency.”

In the European reinsurance sector specifically, the report explains that “risks arising from the low yield environment may urge the reinsurance industry to further consolidate.”

At the same time competition from non-traditional and alternative capital sources are pressuring reinsurance firms.

“Reinsurance premiums have been pressurised as companies face continuing competition from non-traditional sources of capital,” explains EIOPA.

The report continues; “Alternative sources of capital push the sector’s capitalization levels higher and pressure pricing. The rise of alternative capital (AC) is a key risk for the traditional reinsurance market, as it has contributed to lower rates and increased competition.”

EIOPA cites an almost 25% increase in alternative reinsurance capital over the course of 2014, compared to 2013. While that rate of ILS market growth is unlikely to be matched in 2015, alternative capital is becoming more established and accepted all the time, resulting in an expectation that further market share is likely to be taken by ILS fund managers and investors.

As a consequence of the competition posed by alternative capital, reinsurers are “looking at other regions and lines of business to deploy their capital and diversify their exposures,” EIOPA says.

EIOPA explains that the diversifying nature of the returns of catastrophe exposed insurance and reinsurance business, is particularly attractive to investors in search of sources of yield which have a low correlation to wider economic factors.

Given the expectation that corporate debt and bond yields will remain low for the foreseeable future, EIOPA expects that this will “continue to produce more capacity for catastrophe and other reinsured risks.”

Still, the non-traditional capital continues to flow into non-proportional catastrophe exposed lines of business predominantly, but increasingly EIOPA notes that competition from ILS is expanding into other reinsurance lines.

EIOPA also notes that structural factors are making ILS more attractive.

“Investors acceptance of indemnity-based triggers has increased and along with that the spreads have tightened between indemnity and other trigger types,” the report says.

This evolution of ILS to become more comparable to traditional reinsurance coverage is increasing the attractiveness of collateralised protection from ILS players.

EIOPA explains; “This will raise the attractiveness of ILS further for both new and repeat sponsors, which are expected to issue into the ILS market not only for diversification and complement of overall reinsurance purchases but also due to the alternative market’s competitive pricing and broadening indemnity coverage.”

Of course it’s nothing new to consider alternative capital a key risk to reinsurance firm’s, but this is the first time that the EU watchdog has cited it as such. EIOPA said before that ILS is increasingly becoming attractive to insurer and reinsurer sponsors as a source of reinsurance and retrocession.