Ratings agency Fitch Ratings warns that the reinsurers face a ‘potentially permanent erosion of profit margins for reinsurance products‘ due to the impact of alternative capital and insurance-linked securities (ILS) on their core business.
In an article Fitch ratings analysts blame the low-interest rate environment for shrinking reinsurers investment returns while also providing additional impetus for institutional investors to allocate capital to the reinsurance market, in the form of insurance-linked securities (ILS) and collateralized reinsurance capacity.
The growth of alternative reinsurance capital is a more permanent threat to reinsurers, due to the erosion of margins they have become used to relying on. These providers of alternative reinsurance capital are expected to remain as a permanent fixture in the reinsurance industry, says Fitch, even low-interest rates and low catastrophe losses which contributed to the ILS sectors’ growth come to an end.
The scale of the impact of alternative capital on the space will depend on whether it remains focused largely on property catastrophe risks or whether it broadens its remit to other lines of reinsurance business such as casualty risks as well, says the rating agency.
Fitch notes that the rapid growth of alternative capital in reinsurance, which grew by approximately 18% in the first-half of 2014, as well as the wide variety of vehicles leveraged by ILS and alternative capital to provide reinsurance products demonstrate that these capital market alternatives have gained acceptance among primary insurers.
Traditional reinsurers also accept alternative capital and use it to hedge their own exposures or manage it in return for fee income. However, Fitch warns that these benefits are, in the rating agencies opinion, outweighed by the increased competition, margin erosion and pressure on prices.
Fitch says that the two events that could cause a disruption to ILS would be the occurrence of major catastrophe losses or a sharp increase in interest rates. However, Fitch says that even if these do occur it would not expect capital to flee the sector en mass, rather that a significant portion of the capital markets money would stay in ILS in order to continue to benefit from the returns and the low-correlation of the asset class.
Fitch expects the amount of alternative capital allocated to casualty reinsurance to grow, especially with the example set by Watford Re and its approach to underwriting some casualty lines using an efficient business model and capital sources from a similar set of investors.
Fitch is not certain whether a significant amount of alternative capital will make its way into casualty risks, but warns that if it does, the result would be lower casualty reinsurance prices and lower margins spreading more broadly across the market as a result.