In a new report published by rating agency A.M. Best, alternative reinsurance capital is identified as one of the top 10 threats to European insurance and reinsurance companies financial strength and named as a ‘Grey Swan’.
A.M. Best identifies ‘Grey Swan’ events as the known threats to the insurance and reinsurance industry, rather than the unknown threat posed by so-called ‘Black Swan’ events.
The report categorises Grey Swan events into two groups. Those with the potential to deliver a “knock-out punch” to the re/insurance industry, such as a mega-catastrophe event, extreme financial market downturn, or a modeling error leading to significant impairment, versus those the “slow and painful death,” caused by threats such as higher regulatory costs and protectionist practices, or emerging underwriting risks such as cyber terrorism, food security or climate change.
Stefan Holzberger, Managing Director at A.M. Best Analytics, commented on the report; “It is important that insurance companies devote sufficient time and resources toward managing the low probability, high severity risks to their businesses. These are the grey swan events, the known knowns, as compared with the black swan events, the unknown unknowns that are virtually impossible to manage or hedge against. A.M. Best expects securely rated companies to incorporate the potential for grey swan events into their risk management frameworks. These companies’ risk appetites, risk management capabilities and balance sheet strength should be sufficient to withstand the severe stress scenarios discussed in this report.”
Alternative, or third-party, reinsurance capital is featured in the second group, cited as a threat with the potential to cause a slow and painful death for some insurers or reinsurers.
A.M. Best says that the entry of alternative capital into reinsurance, as capital markets investors take an increasing like to the returns provided by direct reinsurance linked investments in instruments such as catastrophe bonds, collateralized reinsurance, ILS funds and sidecars, has the potential to alter the insurance and reinsurance market landscape in a profound way.
A.M. Best notes that while the involvement of third-party capital and institutional investors in reinsurance has positives for the market, such as cheaper risk transfer, more efficient and lower-cost capital, the over-riding threat is one of a permanent soft market cycle.
A permanent soft market could result in traditional reinsurance companies being disintermediated, the report says. The low barriers to entry and competition posed by alternative reinsurance capital is pressuring reinsurer profit margins and could have negative implications for the ratings of the sector as a whole.
A.M. Best notes that the multi-line insurers and reinsurers are those best able to avoid the impacts of these Grey Swan events, but even they could be impacted negatively by a combination.
For some, that perhaps would be the greatest fear. For example the occurrence of a mega-cat event, cited as a potential ‘knock-out punch’ for the industry, could be followed by even greater inflows of alternative capital making it even harder for traditional reinsurers to push up rates or to compete with the rapid influx of additional capital markets money.