Embracing third-party capital a key driver of success for re/insurers

Taking advantage of the interest to allocate capital to generate reinsurance underwriting returns shown by third-party capital investors could be a key driver of success for re/insurers, at a time when underwriting ability is increasingly important, says A.M. Best.

With the reinsurance market under increasing pressure, due to lower returns, excess traditional capital, increasing alternative capital and other macro-economic forces, re/insurers need to focus on underwriting returns and alongside that leveraging the right kind of capital for the right risks, A.M. Best suggests in a new report.

Against the challenging reinsurance market backdrop, traditional companies are continuing to position themselves as “the gatekeepers of insurance risk and manage the risk share and alignment with alternative capital for property and non-property classes of business,” A.M. Best explains.

The rating agency expects that this trend will continue, and we’ve seen further evidence of this alignment in the number of sidecar and collateralised reinsurance special purpose vehicles setting up and recapitalising at renewals.

A.M. Best explains the clear need for reinsurance companies to; “Form larger, global, well-diversified operations with broad underwriting capabilities to assess risk and to serve as transformers of risk to the capital markets.”

This positioning has been adopted by a number of traditional players for some years, with even the largest reinsurers in the world having sidecar vehicles to share some risk with investors. But it is a trend that we will likely see accelerate, as pricing remains depressed and alternative capital provides the most efficient options to make an underwriting profit, even if that profit is shared.

This year we saw primary insurance group Liberty Mutual launching its own sidecar-like vehicle, Limestone Re, providing it with a way to share its risks with third-party capital, while also securing its own source of reinsurance, adding efficiency and fees to its platform.

We could see an increasing number of these types of vehicles launching, as both insurers and reinsurers look to back risks with third-party capital, in order to add capital efficiency and earn fee income.

Motivations to do this differ, of course, with primary companies also benefiting from taking some of their risks out of the renewal cycle, lowering their brokerage fees and providing a third-party capital backed platform for optimising their risk retention as well.

Reinsurers, on the other hand, gain by putting risks that don’t pay so well onto third-party capital which has a lower return requirement then their balance-sheets, while also generating a source of fee income.

So it’s compelling for both a primary insurer or a reinsurer to embrace third-party capital right now.

In fact, it is perhaps more compelling for a primary company with an internal reinsurance vehicle capitalised by investors, due to the ability to avoid brokerage and ceding fees, while that also ramps up the pressure on the reinsurers by taking more risk out of the renewal cycle.

“Reinsurance companies are making the argument that they can best serve insurance companies in terms of matching risk with the most appropriate form of capital,” A.M. Best explains.

However, we’d suggest that working directly with a primary insurer may provide even more value for the ILS or third-party capital investors, as they can finance the risk before it has had margin removed by passing along the chain to reinsurers.

It’s another example of the blurring of lines, as primary insurers look to work with third-party capital increasingly, while reinsurers do too.

The need for efficiency at all stages in the market will likely result in increasing competition as well as conflicts between those standing at different points in the value-chain (brokers likely included there).

And as A.M. Best notes; “This tug of war will result in fewer hands in the pot — ultimately making it better for the purchaser or protection but likely at the expense of some franchises that exist today.”

The reinsurance market looks set to become increasingly driven by underwriting as a greater contributor to profits, making risk selection, diversification of product offerings, geographic reach and conservative reserving practices all key, A.M. Best says.

But it also makes it important that reinsurers are ready and able to use the right capital to back the right risks, including embracing third-party capital to help in that goal.

“The ability to take advantage of the new “cheaper” capital coming into the market from investors that do not have the reinsurance and underwriting expertise,” alongside the skill in underwriting and diverse product range “could actually lead to significant success for some, although not everyone will win in the end,” A.M Best said.

Companies who have “created expertise in managing third-party capital to their own advantage” will be among the winners, the rating agency says, highlighting the importance of this trend and the fact it can be expected to continue and grow.