Managing third-party capital may be “wave of the future” for reinsurers

Capital management for reinsurance firms is getting more complex as they increasingly have to factor in a  new form of capital, managing third-party capital, which from a reinsurers’ perspective is becoming a “wave of the future”, according to insurance rating firm A.M. Best.

The jury’s still out on whether managing third-party capital is going to be a permanent feature of the reinsurance market and a reinsurers daily capital management work, said A.M. Best in a report published yesterday, but that hasn’t stopped many traditional reinsurers launching third-party capital management initiatives as they attempt to keep up with the curve.

A.M. Best’s Global Reinsurance Segment Review discusses the capital challenge that reinsurers find themselves faced with at the moment. Traditional reinsurers find themselves awash with excess capacity, affecting pricing and making the market very competitive, but at the same time A.M. Best said another hurdle has appeared in the form of third-party capital.

While the capital markets tended to provide capacity on the tail end of property catastrophe risks, through instruments such as catastrophe bonds, industry loss warranties and other collateralized reinsurance structures, A.M. Best said that it now looks like investors, asset managers and bankers are beginning to show more interest in lower layers of catastrophe risk as well as other specialty and casualty classes of business.

This broadening of the focus for third-party reinsurance capital is a slow process, with a small number of collateralized reinsurers and insurance-linked securities investment managers testing the waters in new areas of the reinsurance market. So far there is no way of knowing how wide the collateralized market may spread its reach, but it’s certainly a trend that the traditional reinsurers are watching closely.

Investors such as hedge funds, pension funds and endowment funds are increasingly attracted to what they see as an asset class with good returns, low correlation and also a possibility to acquire investment float. A.M. Best said that while some will tell you that this capital is opportunistic, others on the front line attest to it entering the market methodically and precisely, not just rushing in with no clear strategy or understanding.

Capital has been entering the market in many ways, through reinsurance-linked investment funds, invested in catastrophe bonds and ILS deals, from hedge funds directly into new reinsurers, via sidecars established to offer additional capacity and flexibility, or in partnership with existing reinsurers through newly formed collateralized facilities.

This managed, third-party, capital should allow reinsurers greater flexibility with their capital throughout the underwriting cycle, said A.M. Best, providing low risk income from management fees and commission. This revenue can offset the fixed costs which would otherwise go to the reinsurers bottom line, meaning they can acquire new business, make some fees and not see the new initiatives become a capital burden.

A.M. Best’s report notes that the stickiness of third-party capital is still questionable and reinsurers remain aware of the potential for reputational risks and the need to ensure capital providers are long-term partners. Best said that it is pension funds which are most likely the biggest influence on the reinsurance market right now, controlling vast amounts of capital in the industry.

Best notes that pension funds have taken time to learn about the reinsurance sector and become comfortable with the cyclical nature of reinsurance. Pension funds are typically long-term investors and so more suited to the reinsurance market than other third-party capital providers such as hedge funds which can have a shorter term horizon on their allocations to the space.

The trend for reinsurers to start to make efforts to launch third-party capital management initiatives suggests that traditional reinsurer management teams believe that third-party capital will remain in the reinsurance market for some time. It also shows that they understand the need to offer a professional and quality money management platform in order to attract capital. This shows a different mind-set compared to the trend for setting up ‘disposable reinsurers’ after major catastrophe events, said A.M. Best.

A.M. Best see’s traditional reinsurers moves to embrace third-party capital as both defensive and offensive, as they seek to demonstrate success in attracting and managing capital from investors so they will have a track record to show if this does indeed become the “wave of the future”.

A.M. Best believes that with the help of third-party capital traditional reinsurers may be able to weather a softer market. It said;

“Traditional reinsurance companies may be able to emerge from this soft market in a strong position by sharing the brunt of any future losses with third-party capital, a vast majority of which then quickly exits. That will be the trial by fire. Until the staying power of recent third-party capital is tested by the wrath of a major loss, reinsurers will jockey for position to make sure they have a horse in that race.”

A.M. Best said that it can only believe that the abundant capacity will result in lower underwriting profits for reinsurers, which combined with reduced investment income may weigh on traditional reinsurers results. It’s hoped that fee income from managing third-party capital may help to close this gap somewhat and that this new capital may also help to make the reinsurance cycle less peaky in future, bringing stability for all. Cycle management becomes ever more important for reinsurers and Best said that third-party capital can become a tool reinsurers can use to help them manage the cycles of the reinsurance market.

A.M. Best notes that sourcing capital may now be an easier job than sourcing profitable risks to underwrite for reinsurers. This is the main value add that a traditional reinsurer can offer to third-party capital, access to risks through relationships built over years. Best also said that the added revenues from managing third-party capital will enhance reinsurers earnings and also help to solidify client relationships by offering new capacity at prices which may otherwise have been unobtainable.

Of course offering third-party capital to clients at a lower cost may be cannibalising use of reinsurers existing capital so program structuring, what capital is used to underwrite where in a program, becomes ever more important to reinsurers as they manage third-party capital.

A.M. Best said that it is holding its outlook on the global reinsurance sector as stable, for now, but that there remains a concern that reinsurance pricing and terms and conditions may come under pressure as excess capacity continues to build and the convergence between traditional and third-party reinsurance capital continues to evolve.

You can access the full report from A.M. Best, which you may need to purchase, via this press release.