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

Alternative capital is having such a dramatic effect on the reinsurance market that the result will be a change to the reinsurer business model and a major impact on typical reinsurance pricing dynamics, according to ratings agency Moody’s in its latest report on the global reinsurance market.

Moody’s gives the global reinsurance industry a stable outlook, despite the headwinds it so clearly faces at this time, reflecting the sectors resilience, underwriting discipline, improvements in risk management and price firming in some primary insurance markets.

The key challenges that Moody’s notes that the global reinsurance market is facing in 2013, and will continue to face into 2014 and beyond, are continued low-interest rates impacting investment returns, slower demand for reinsurance in some markets due to economic conditions and, above all, the increasing competition from alternative reinsurance capital.

Moody’s estimates that over the past year as much as $10 billion of new alternative capital has entered the reinsurance market, which it believes raises the total amount of alternative capital in the sector to $44 billion, citing Guy Carpenters figures from earlier this year.

This influx of capital has had a major impact on reinsurance market pricing dynamics and exerted signficant pressure on property catastrophe reinsurance pricing, with the June and July U.S. reinsurance renewals seeing rates down by 10% to 20%, according to Moody’s.

However, Moody’s does feel that any adverse affects from these headwinds will be relatively contained, especially as reinsurers adapt to cope with the challenging environment and the evolving marketplace for reinsurance and risk transfer.

“Key strengths of the sector are its resilience and underwriting discipline. Despite immense insured catastrophe losses in 2011 and 2012, and a low interest rate environment that has slashed investment income, the reinsurance sector remained profitable and increased its equity capital”, commented James Eck, Vice President & Senior Credit Officer at Moody’s.

At a pre-Monte Carlo press briefing held this morning, September 4th, Eck said that Moody’s expects that going forwards alternative capital will have a real impact on the markets pricing dynamic. He noted that inflows of capital may remove the amplitude seen in the market, flattening peaks after events, making it harder for reinsurers to secure a larger payback after major catastrophes in the future.

Of course we cannot know how the market will react post-event and even the alternative capital providers will want to see rate rises, and a payback, after any major catastrophe losses. The question is whether the alternative capital will be able to accept lower rate rises than traditional reinsurers might be looking to achieve. Moody’s notes that the pool of institutional investors attracted to reinsurance is very large and capable of quickly filling any supply or demand imbalances post-event.

“While a continued inflow of alternative capital has the potential to alter the core business model of reinsurers, many firms in the sector have been preparing for this eventuality for years through their participation in sidecars and the insurance-linked securities market”, added Mr. Eck.

Eck also commented at the press briefing this morning that there is some uncertainty over the profitability of such reinsurer-backed ILS and collateralized reinsurance ventures. This is an interesting point, as at this early stage in the evolution of the alternative capital market in reinsurance we don’t yet know how much the management of third-party capital will contribute to a traditional reinsurers balance sheet, or whether it will compensate for traditional business potentially lost.

On sidecars, Moody’s report suggests that we will see these vehicles broaden their focus outside of pure property catastrophe into areas such as casualty risks. That would make a lot of sense for traditional reinsurers, as it would give them an opportunity to demonstrate the value they add through underwriting expertise, in lines of business that are perhaps more tricky for investors to access directly.

Moody’s said that hedge funds may find this particularly interesting, as sidecars with long-tail risks may give them the ability to manage and invest the premium or float for an extended period of time.

Moody’s views sidecars as more of an opportunity than a threat to traditional reinsurers, unlike catastrophe bonds and other ILS and collateralized vehicles, as they can be integral to the risk selection process and ongoing management of a sidecar. It also allows them to use third-party capital to underwrite larger line sizes, or write risks that are outside of their typical offerings, for clients. Of course Moody’s also acknowledges that sidecars could further pressure pricing or even cannibalise reinsurers core business by adding lower cost capacity, so there are risks attached.

Moody’s expects that it will be the traditional reinsurers with large capital bases, a high degree of diversification within their business and the ability to utilise and manage both traditional and third-party capital within reinsurance underwriting  that will be positioned best for the future.

Moody’s believes that alternative reinsurance capital is here to stay, aligning itself with most other commentators. You’d be hard pressed to find anyone who would suggest that third-party capital might disappear anymore.

Moody’s said that investor interest could change, depending on interest rates and catastrophe loss experience, but it believes that increased investor familiarity with ILS and reinsurance, growing sophistication of investors, standardization of products and availability of risk models to reduce the asymmetry of information between risk buyers and sellers all point to future growth for the asset class.

Moody’s notes in the global reinsurance outlook report that the influx of alternative capital into reinsurance is not all bad news. It opens opportunities to transfer tail risks to the capital markets and third-party capital and brings revenue opportunities to successful managers of risk.

Moody’s had some comforting words for reinsurers, saying that it believes; “The partial disintermediation of commoditized catastrophe reinsurance is not necessarily a lost opportunity for reinsurers.”

That is a statement that reinsurers visiting Monte Carlo for the Rendezvous this weekend would do well to remember, particularly if they have heeded the words of Dominic Christian of Aon Benfield on becoming more flexible and learning from ILS and collateralized markets.

Subscribers to Moody’s services can access the full report via this press release.

Also read our other recent article on the disruption that the reinsurance industry is facing: Alternative capital a disruptive force in reinsurance: Goldman Sachs.

More reading:

There are so many reports and commentaries coming out on alternative reinsurance capital and ILS in the run up to 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