Retrocession market exposed to collateral lock-up risk: Validus Re CEO

The retrocessional reinsurance market could become volatile after a major industry loss event, as the amount of fully-collateralized cover in that market might result in a considerable amount of global retro capacity being locked up.

This is according to Validus Re CEO Kean Driscoll, who highlighted the high percentage of collateralized capacity in the global retrocession market during the second-quarter earnings call of Bermuda-based insurance, reinsurance and third-party capital management specialist Validus.

Driscoll noted that the retro market has been particularly affected by the influx of alternative or third-party capital from capital markets backed players, with much of the new capacity coming from fully-collateralized sources.

That has now resulted in a retro market that is dominated by collateralized and insurance-linked securities (ILS) funded capacity, he noted, and as the percentage of the market that is collateralized grows the risk of a major event causing lock-up increases too.

“The retro market presents some very interesting dynamics that are worth discussing,” Driscoll said.

Despite the influx of new capacity into reinsurance and retro markets, he noted that; “the retro market and perhaps the broader CAT [catastrophe reinsurance] market is more fragile than one would otherwise believe.”

“An extremely large percentage of the global retro capacity is sold by a small number of markets,” Driscoll continued. “We believe that six markets account for approximately 60% of global retro capacity.”

This is easy to believe. The collateralized retrocession market has become dominated by reinsurance and retrocession focused ILS fund managers, which have taken growing shares of the market in recent years.

Driscoll continued; “These are collateralized markets that are heavily exposed to both large, single occurrence events as well as an aggregation of events.

“And given that capacity is collateralized, it’s not going to take a $100 billion event to lock up a big portion of the industry capital supporting CAT writers.”

Now we’d imagine (hope) that the large collateralized retrocession underwriters have plans in place for just such an eventuality, if a particularly bad aggregation of events across a number of their risk pillars resulted in capital being locked up, as had been seen in 2011/12.

It has to be said that that the way collateralized retrocession markets dealt with side-pocketing of potentially impaired investments was admirable and there was no capacity crunch as a result of lock-up from what was a particularly heavy period of losses.

However, Driscoll warns; “While supply currently exceeds demand for CAT risk and the financial apparatus exists to allow for an easier entry of new capacity into the market, a large U.S. event or series of events very well may result in short-term volatility in the cat market.”

It’s an interesting point, but as we said we hope that managers have planned for this.

The largest retro markets in the world tend to diversify their portfolios on a pillar-by-pillar of risk or peril basis, meaning that they hope to only perhaps see 20% or 30% of each portfolio exposed to the very largest of catastrophe loss events at one time.

Yes, an unfortunate aggregation of major losses could result in a collateral lock-up that might be testing, but it is likely that after such an event large capital market investors in retro markets would be ready to recapitalise to take advantage of any rebound in rates, so capacity may not crunch for long (if at all).

It’s also worth noting that it’s not easy for traditional reinsurers to recapitalise after such severe loss scenarios and also other collateralized reinsurance (rather than retro) focused ILS funds would also face collateral lock-up risks after such events.

Driscoll did note that Validus saw retro market demand increase in Q2, with “significant new purchases of both UNL and ILW protection, which absorbed U.S. wind aggregate and contributed to rate change moderation.”

So at the moment the retro market seems to be experiencing a similar moderation in price declines as that witnessed in catastrophe bonds and other ILS markets. That’s good news for the broader reinsurance market and perhaps further evidence of an emerging pricing floor.