Alternative capital as significant to reinsurance as emergence of Bermuda: S&P

Competition from third-party and alternative capital in reinsurance is of similar significance to the sector as the emergence of Bermuda as a reinsurance hub and the entrance of its companies over the past two decades, according to Standard & Poor’s in a paper on the global reinsurance sector.

In another pre-Monte Carlo report, S&P discusses the rising tension in the reinsurance market as it gets to grips with a new market dynamic, partly caused by the influx of third-party capital from institutional type investors. Reinsurers have a lot to think about, according to S&P, from pricing pressures, to where profits are coming from, to finding prospects and competing with new players.

Excess capital in the reinsurance space is increasing competition among reinsurers at a time when they are facing a new competitive threat from the growing alternative reinsurance capital and insurance-linked securities space. This is pressuring reinsurer profits at a time when the wider macroeconomic environment is also threatening the earnings prospects and capital base of reinsurance firms.

In this environment, S&P see a likelihood that the better prepared reinsurers will be in a position to capitalise on the new dynamic and thrive, while those that aren’t prepared and willing to adapt may find themselves marginalised and subject to potential consolidation.

Reinsurers remain stable in terms of outlook according to S&P, all the rating agencies currently maintain a stable outlook on reinsurers largely due to their strong capitalisation. It will be interesting to see whether the outlook remains the same after the January renewals or how it might be affected by a large catastrophe loss event.

S&P sees certain parts of the reinsurance market becoming commoditized, with the success of the market helping to attract new forms of capital, some third-party sourced, increasing competition. S&P said that it sees the competition provided by third-party capital as of similar significance to the entrance of Bermuda companies into the reinsurance space over the last two decades. but it expects existing firms will learn to adjust and find a way to coexist with this new capital, as S&P notes it has done before.

Some changes to the reinsurance sector are likely, said S&P, but, while this influx of capital markets derived capacity is significant, it does not believe it is evidence of a wholesale structural shift in the competitive landscape.

Reinsurers will need to find ways to differentiate themselves from both traditional and new competitors though, said S&P, in order to maintain relevance and a competitive advantage. Innovative ways to expand coverage need to be found, in order to provide traditional reinsurers with new opportunities where they can specialise.

S&P notes that reinsurers have typically driven innovation in product areas such as catastrophe bonds, insurance-linked securities (ILS), cyber risks, kidnap and ransom coverage and longevity solutions. This type of innovation needs to continue and accelerate in order for companies to survive, but only where the risk and reward provides a suitable return.

S&P then discusses the stickiness of alternative capital, asking whether it is a structural shift or a flash mob. It believes that if interest rates and yields on more traditional asset classes were to revert to historical levels over time, it could make ILS and reinsurance a less attractive proposition for investors and they may shift back to the more traditional asset classes.

While this is certainly true for some investors, there is always an element of opportunism and speculation in every investment market, we know that a reasonable amount of the alternative capital in reinsurance and ILS now comes from investors with typically longer investment horizons, such as pension funds.

For these investors the return profile and diversification benefits of remaining in reinsurance and ILS will likely mean they continue to invest in it as an asset class for the forseeable future.

S&P asks how reinsurers will react to this ‘new normal’, of alternative capital being deployed into underwriting in many of the most profitable property catastrophe reinsurance zones. It says that remaining complacent is not an option, as reinsurers could find themselves marginalised and acting purely as a conduit for passing risk to the capital markets. That is definitely one possible outcome and we may well see some smaller reinsurers moving towards this type of business model if the trend persists.

However, S&P has noticed the emerging trend for reinsurers to prepare themselves by establishing their own third-party capital management facilities, acting as issuers, investors or advisors in the space. We think it is worth asking whether this is just a precursor to the above happening, and the beginning of a structural shift in the market, but S&P itself does not believe so at this time.

S&P does acknowledge that reinsurers are, to some extent, cannibalising their own business by issuing sidecars and catastrophe bonds, or investing in and establishing ILS funds and other structures. It calls this a zero-sum game and S&P says that further consolidation is a likely response to less business.

While S&P believes that alternative capital is likely to be transitory, when interest rates pick up or a large catastrophe event occurs, it does not believe that this will happen in the next 12 to 24 months. In fact, S&P believes that even more capital could enter the market at the January renewals.

While S&P seems to expect a lot of investors will lack stickiness needed to be relied upon in the reinsurance market it does acknowledge that there are dedicated investors who will continue to play an important role in the market over the longer term. The question is how much capital those dedicated investors will wield, if it continues to increase, with the backing of pension funds, then the more transitory investors pulling back is not going to be sufficient to take the pressure off traditional reinsurers.

S&P says that despite all the hype and coverage of alternative reinsurance capital and the insurance-linked securities market, it does not expect ILS issuance this year to surpass historic highs. It forecasts $6 billion to $7 billion of catastrophe bond issuance in 2013, nearly equal to the high seen in 2007, but it does not expect sidecars to reach the nearly $3.5 billion seen in 2006.

Now, S&P is likely only thinking about rated catastrophe bonds in its figures and does not refer to the more rapid growth of collateralized reinsurance, taking reinsurance contracts and turning them into financial instruments in private ILS deals or the financial insurance contract market.

Since 2007 the market has changed dramatically and while rated, 144A catastrophe bonds may not reach there high this year (although there is a chance they might given the forward pipeline) we feel you have to consider the way the market has evolved and matured in other instruments using alternative capital.

The report goes on to discuss in detail the other factors impacting traditional reinsurers at this point in the reinsurance markets history. S&P closes by saying that marginalisation, commoditisation or consolidation will be the result for reinsurance firms which have not prepared themselves for the changing marketplace, but conversely it believes some reinsurers are well positioned to deal with the headwinds.

You can access the full report if you subscribe to S&P’s RatingsDirect service.

More reading:

There are so many reports and commentaries coming out on alternative reinsurance capital and ILS in the run up to and at the Monte Carlo Rendezvous event that we felt it worth highlighting some other reading on the topic, all from the last week or so, which you can find below (most recent first):

– Demand for alternative reinsurance instruments and ILS to continue: Fitch

– Alternative capital the biggest challenge for traditional reinsurers: Moody’s

– Lloyd’s Nelson warns on ‘systemic’ risk of alternative reinsurance capital

– Broker facilities an opportunity for third-party capital to expand reach?

– Opportunity for reinsurers to learn from ILS: Aon Benfield CEO

– Capital markets investors boost global reinsurer capital to $510 billion (including a useful list of links to many alternative reinsurance capital initiatives that we have covered previously)

– Strong capital inflows bring ILS & cat bond market to new high: Aon Benfield

– Alternative capital a disruptive force in reinsurance: Goldman Sachs