The ninth in this series of articles involving leading figures from the insurance-linked securities (ILS) and reinsurance arena on the prospects for the market in 2015 features Kevin Lee from Moody’s Investors Service.
We asked for participants thoughts and predictions about the ILS market, catastrophe bonds, collateralized reinsurance and reinsurance or catastrophe risks as an asset class as we move into 2015.
Kevin Lee is a Vice President and Senior Credit Officer at Moody’s Investors Service. He is focused on financial services analysis and ratings and as a result covers the catastrophe bond and ILS market, as well as market trends across insurance and reinsurance capital.
Kevin, assisted by colleagues, provided some thoughts on what we might see in the market as 2015 progresses, with a particular focus on reinsurance buyers and the implications of recent market trends for insurers and reinsurers.
The response follows in full below:
In 2015, we expect that insurers will continue to extract cheaper rates and broader terms and conditions from reinsurers. As a result, reinsurers will likely struggle to earn their cost of capital while insurers will remain firmly in the driver’s seat, benefitting from abundant traditional reinsurance capacity as well as cheaper alternatives to traditional reinsurance (see our 2015 Reinsurance Outlook for a discussion of secular trends driving reinsurance demand, M&A, and swing factors to our negative outlook).
Credit spreads summarize this tale of two sectors. Investors are most positive on P&C insurers and most negative on reinsurers. As this exhibit shows, US P&C names continue to trade with the biggest positive rating gap (i.e., rating implied by CDS spreads is higher than Moody’s rating) while global reinsurers trade with the biggest negative rating gap (i.e., rating implied by CDS spreads is lower than Moody’s rating).
A question we want to explore in 2015 is whether the fortunes of insurers and reinsurers can continue to diverge given that the two sectors rely heavily on each other and act as counterparties to each other (therefore creating counterparty risk). In other words, is it possible to have a healthy insurance market but, at the same time, an unhealthy reinsurance market?
While insurers will once again get the better of reinsurers in 2015, we believe this gravy train cannot go on indefinitely without some negative consequences for insurers, which include:
- Cheap reinsurance will help fuel competition in primary insurance markets, leading to some margin compression for US primary insurers in the second half of 2015, we believe. Cheaper reinsurance has already encouraged insurers to cut commercial property insurance prices (quite dramatically in some cases) but hasn’t fueled widespread competition in casualty insurance yet because low interest rates have encouraged underwriting discipline. However, casualty reinsurance rates are falling precipitously to the point where US professional lines ceding commissions above 30% are not uncommon. As a result, we expect that casualty insurance pricing will continue to moderate in 2015 given the likelihood that US interest rates will rise and that casualty reinsurance will become even cheaper.
- Changes in reinsurance buying behavior raise new questions about counterparty risks. As insurers continue to centralize/consolidate their reinsurance purchases and shrink reinsurance panels, counterparty risk will be concentrated in a fewer number of reinsurers. To complicate matters, insurers are demanding broader terms and conditions and more bespoke structures from reinsurers. Even though these structures generally have longer and broader terms, they are not permanent forms of capital. Ascribing capital credit to these structures is challenging in practice. It is equally difficult to assess how much capital a reinsurer must tie up when offering these bespoke structures. The growing use of alternative capital also raises counterparty risk issues. In part, our internal discussions will focus on whether we should haircut reinsurance credit we give for alternative capital. While upfront collateral looks good on paper, our experience with triggered cat bonds makes us question whether insurers will be happy with the (sometimes) rigid chain of custody for claim payments.
- Lower returns could limit the dependability of alternative capital. Alternative capital providers seem to be facing just as much competition as traditional reinsurers. Despite a nearly loss-free year in 2014, ILS funds recorded one of their least profitable years on record, producing around a 5% return on average according to the Eurekahedge ILS Advisers Index (based on data reported as of 8 January 2015). This level of performance falls below the target returns of some pension funds and other ILS investors, some of whom have already pared their exposure in the asset class. We would not be surprised to see more ILS funds start to return capital or perhaps even head for the exits in 2015. That said, the current volatility in the high-yield bond market could bolster appetite for ILS.
Our thanks to Kevin Lee and his colleagues at Moody’s for their time.
Like to be featured in an interview on Artemis or have some thoughts on the market for 2015? Contact us to discuss.
Artemis’ Q4 2014 Catastrophe Bond & ILS Market Report – A busy finish to a record year for ILS
We’ve now published our Q4 2014 catastrophe bond & ILS market report.
This report reviews the catastrophe bond and insurance-linked securities (ILS) market at the end of the fourth-quarter of 2014, looking at the new risk capital issued and the composition of the cat bond & ILS transactions completed during Q4 2014. It also includes a brief review of the full-year 2014’s record issuance.