Alternative capital may squeeze out equity capital in reinsurance: Willis Re

As alternative capital, sourced from institutional and other third-party investors, continues to flow into the reinsurance market at pace thoughts at the Monte Carlo Rendezvous event turn to how this will change the structural landscape for reinsurers. One possible end result could be a displacement of traditional equity reinsurance capital, according to broker Willis Re.

At reinsurance broker Willis Re’s press briefing held on Sunday at the reinsurance Rendezvous event, executives suggested that we should expect to see the influence of alternative capital in reinsurance grow.

Dominic Casserley, CEO of Willis Group, suggested we’re still in the early days of the insurance-linked securities and third-party investors interest in the space, saying that alternative capitals interest in reinsurance is growing and it is even beginning to show an interest in primary insurance business.

John Cavanagh, CEO of Willis Re, discussed the trend at length, providing an overview of the alternative capital space and a number of interesting and relevant comments. He said that alternative or new capital, is not entirely new. In fact a lot of this type of capital has been in the market for many years, just not in its current form and certainly not in the same concentrations.

He said that the trend will lead to significant change in the market for traditional reinsurers, but that shouldn’t mean a lack of opportunities for those reinsurers who find ways to adapt to the changing dynamic. Reinsurers should expect traditional reinsurance structures to be “turned on their heads”, as a result of which reinsurers have to be ready for change.

Tony Ursano, CEO of Willis Capital Markets & Advisory, the firms ILS and capital markets specialist unit, said that reinsurers need to be proactive and find efficient ways to participate in the third-party capital trend.

Cavanagh said that reinsurance as a whole is changing, demand is growing for more complex, global, multi-line protections, interest in retrocession is increasing and reinsurance purchasing is moving to the C-Suite where CFO’s and CEO’s are now making reinsurance purchasing decisions across their enterprises.

As part of this change, Cavanagh explained, appetite is growing for tail catastrophe risk protection, opportunistic buying of reinsurance to hedge against the deteriorating rate picture, multi-year and multi-class covers, surrogate capital structures, such as the Lloyd’s market has been working to encourage and of course the increasing utilisation of new capital sources.

Willis Re see the amount of alternative reinsurance capital in the catastrophe reinsurance market as approximately $50 billion. This could grow significantly, Cavanagh suggested that another $100 billion could flow into the market and alternative capital could account for as much as 30% of the global property catastrophe reinsurance market within a few years.

Continuing heavy inflows of non-traditional capital could have a profound effect on the reinsurance market and reinsurers may face structural and economic challenges, as the way they capitalise has to change to accommodate and embrace alternative capacity from investors.

One of the results of this could be that equity capital becomes crowded out of the market, to some degree. This would be a major change in the way reinsurers do business, with the rated balance sheet perhaps shrinking in favour of lower cost, more agile, alternative capital.

John Cavanagh commented; “Discussions so far have centred on the effect third party capital is having on rates and the competition it is producing in the property catastrophe reinsurance market. A future influx of $100 billion would, however, have a number of profound consequences. As third party capital enters the property cat reinsurance market, it is going to crowd out conventional equity capital. That equity capital has to go somewhere.”

Cavanagh explained that traditional equity reinsurance capital is being squeezed out by alternative capital flowing in. He painted a picture of up to $100 billion of alternative capital coming into the market, which as a result he said could displace as much as $30 billion to $40 billion of equity capital.

Some of this would be returned to shareholders, but $20 billion in excess or more may be redeployed. Cavanagh said; “You could think of this as being the equivalent of 10 well capitalised start-up companies, and the effect on the market place would be profound. If capital is redeployed, much of it could go into direct insurance businesses. Many of the hybrid specialty reinsurers are already implicitly going down this path.”

Traditional equity reinsurance capital may find itself squeezed out by alternative capital - Source: Willis Re

Another result of this structural change could be a deeper secondary market in reinsurance, as much of the new capital coming into the market is seeking price discovery and liquidity. Cavanagh said that this could result in growth of catastrophe bond trading, derivatives, options, swaps or forms such as replicats, with index-based trading one likely mechanism.

Interestingly, Cavanagh suggested that what is needed for a deep secondary market to form is price discovery and trading platforms or exchanges, allowing capital to come into reinsurance and trade risk, for which markets are perhaps the best solution. Intriguing, particularly as this comment came just as we published our exclusive news that PCS is working with the Cayman Islands Stock Exchange to launch traded catastrophe derivatives and options on the exchange. A very timely comment from Cavanagh.

Tony Ursano of WCMA commented that he expects third-party capitals interest in reinsurance will eventually drive mergers and acquisitions in the reinsurance space.

In terms of the size of the alternative reinsurance capital market, Ursano said that this could be anything up to $150 billion by 2020. However, currently demand outstrips supply and asset managers, particularly ILS, are having to turn capital away as they lack opportunities to deploy it.

Ursano said; “On the capital markets side, we expect a very active cat bond calendar, including new and renewal sidecar financings, additional activity around new insurance-linked securities fund formations and strategic partnerships, as well as more new hedge fund sponsored reinsurers.”

Catastrophe bonds continue to be in favour, and Ursano expects further growth in this space, particularly as cat bond returns continue to be more attractive than other high yield bond investments. The diversification factor is also key here and Ursano said he expects investors such as pension funds will continue to deploy new capital even if the yield was not such an important factor.

Investors in the cat bond, ILS and alternative reinsurance market now have long-term investment horizon and spend significant time getting to grips with the asset class. They are not temporary investors and Ursano said he expects much of the capital will stick around and more is on the way.

For the market to grow to $150 billion expansion into new territories and perils is required. Ursano said that many in the ILS space are already putting significant time into research and development on new products which can help the asset class to expand beyond its catastrophe risk walls. Casualty is a major focus here, but so are other areas such as commercial auto and D&O.

In this expansion quest traditional reinsurers have an opportunity to participate and leverage their extensive underwriting experience to guide new capital to the best opportunities. Here a partnership could emerge, if the traditional and the new can find a way to get along.

On cat bonds, Ursano said that to date WCMA counts $4.96 billion of issuance to date in 2013. He said the pipeline for the remainder of 2013 looks strong and he expects another 8 to 12 cat bonds by year end which should take issuance to over $7 billion and may break the record of 2007. This $7 billion of cat bonds will support approximately $700m of premiums, not insignificant at all in terms of the reinsurance market.

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):

– Lloyd’s Nelson: Alternative capital can help insurance grow to $2tn by 2025

– Insurance-linked securities market calling for innovators: PwC

– Catastrophe bond market may hit $23 billion by end of 2016: GC Securities

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

– 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