The capitalisation of the reinsurance business is changing

The way the reinsurance business is capitalised has changed over the last decade, as an increasing amount of capacity funded by capital market investors has entered the sector seeking to benefit from the returns possible on reinsurance business.

This trend has accelerated in the last few years, particularly rapidly in the last twelve to eighteen months, with traditional reinsurers now increasingly looking to lower their cost-of-capital by managing investors money in-house and utilising it within their underwriting activities.

In its latest report on global reinsurance capital and the group of reinsurers it calls the Aon Benfield Aggregate, broker Aon Benfield called the activities seen at reinsurers, in establishing third-party capital management units and sidecars, “The beginnings of a true rotation in how the reinsurance business will be capitalized.”

This rotation, or perhaps evolution, in the reinsurance business model is being driven by capital and the need for reinsurers to be able to compete with lower-cost capacity being deployed directly into reinsurance business. This has led to an increasing number of reinsurers seeking to leverage funds from third-parties directly as an attempt to lower their own cost-of-capital.

Despite being awash with shareholder equity backed capital, after a year of low catastrophe losses and high profits at reinsurers, the drive to accommodate third-party capital is increasing. Reinsurers are tending to return equity capital, through share buybacks and dividend increases ,while at the same time often taking on more capital into newly established third-party capital management units, in structures like sidecars and funds.

Aon Benfield hints that in some cases the return of capital may be a lever to enable reinsurers to accommodate more capital which comes with a reduced cost. The brokers report says; “Repatriation of equity capital in the form of dividends and share buybacks rose by 15% to USD20 billion, partly reflecting the increasing engagement of third party capital.”

Mike Van Slooten, Head of the International Market Analysis team at Aon Benfield, said; “Reinsurers have reported resilient results in an increasingly competitive marketplace. Most are now adapting their business models to accommodate the increasing availability of lower cost capital, thereby enhancing both their risk transfer capabilities and their offering to clients. We expect capital management activity to accelerate, as the advantages become more apparent.”

Aon Benfield’s report says that the leading reinsurers which have engaged with third-party capital, mainly sourced from pension plans, life insurers, endowments and high net worth individuals, are beginning to find new income streams and operating advantages as a result of these efforts.

This is really a key point for reinsurers which have decided to embrace third-party capital and ILS wholeheartedly, especially those who have done so recently. If a little late to the game these reinsurers need to see benefits from managing and utilising third-party reinsurance capital quickly, as in the current market environment the time to incubate these ideas has to be fairly rapid.

With pricing declines continuing reinsurers do not really have the time to experiment with third-party capital. They need to see incremental benefits to their profits from these activities as now is not the time to cannibalise their existing business using capital that only earns them fee income.

Aon Benfield lists activities where reinsurers are finding success using third-party capital. These include, sponsoring catastrophe bond transactions to reduce the cost of their own reinsurance or retrocession particularly for peak modeled perils, sharing their underwriting performance as well as reinsurance and insurance relationships through allowing investors to participate in sidecars and other managed vehicles and managing bond funds where they have relationship and familiarity benefits with bond sponsors.

These activities demonstrate the beginnings of this rotation or evolution of the reinsurance business model, with capital, particularly the cost of it, driving new ways to finance risk transfer, share the proceeds of reinsurance underwriting with investors and helping reinsurers to boost line sizes and bolster relationships further.

The amount of capital available to these evolutionary reinsurers is increasing, with the pool of investors in insurance and reinsurance linked strategies growing all the time as education about the asset class accelerates and spreads more widely.

This is resulting in a structural shift in the way capital is raised and deployed to mitigate insurance risks, a fundamental change that has been happening slowly for the last decade or two but has recently accelerated dramatically, which promises to become a core part of the reinsurance model in future.

Structures which offer access to reinsurance and insurance business at lower costs are successfully attracting new capital and hence the reinsurance market is evolving its business model to take advantage of this interest from institutional and capital market investors.

The new third-party capital backed reinsurance vehicles are able to operate at a cost-of-capital which is lower than the typical traditional reinsurance business model and are making inroads into areas of the market which have been key drivers of profits for reinsurers.

As a result reinsurers are being forced to respond, explains Aon Benfield, with many choosing to; “Rethink their business models in the pursuit of differentiation and relevance in the market.”

In catastrophe reinsurance, where the competition from lower-cost capital and ILS, as well as from the capital-heavy traditional players, is strongest reinsurers increasingly need to be able to offer larger line sizes, a full suite of products including fully-collateralized reinsurance limit and an enhanced claims service.

This means that the reinsurers which successfully integrate third-party capital into their reinsurance product offering can enhance their client offering, reduce the volatility of their earnings by adding fee income, lower the cost of their own risk transfer and better manage their own capital bases.

Of course what this does not really account for is the profit difference between underwriting on a reinsurers own paper versus using third-party capital and paying fees. It’s very possible that the difference will be negligible for those reinsurers that successfully leverage third-party capital as a way to expand existing business and to lower their own risk transfer costs, as well as sign larger lines. Those who don’t manage the adoption of third-party capital well may find it taking its toll on their expense ratios, as better profiting business is given up in favour of business that also has a fee attached.

The fact that the reinsurance business model is changing or evolving cannot be disputed. We’ve seen the rate of change accelerate in recent months, as the pricing environment has forced those who perhaps held back from embracing new capital to also come forwards with new initiatives.

Pursuing change in order to remain relevant does perhaps come with dangers attached. Not all these third-party capital activities will succeed and not every reinsurer will be able to lower their cost-of-capital while still maintaining enough profit to continue to operate as a distinct entity. Hence the merger & acquisition discussions which are increasing in frequency in the market right now.

It is perhaps a time to be daring though. Often, when a market is in flux this is the right time to be innovative, to try something new and to embrace the latest technologies and tools to improve profits and profitability. We’re beginning to see some evidence of reinsurers looking to embrace innovation, to think again about product design, to bring elements of the innovative worlds of technology and startups into their businesses as they seek to differentiate themselves from the rest of the industry.

Again these efforts won’t all be successful, but they do perhaps give traditional reinsurers more of a chance than those who sit back hoping that the status quo of typical reinsurance market cycles return after the next big catastrophe event.

With no guarantees that reinsurance pricing will ever revert to the levels seen in recent years, at least not on property catastrophe perils in well-modelled markets, sitting back, doing nothing and hoping everything goes back to normal is not really an option anymore.

Here are a selection of recent articles from Artemis which discuss these reinsurance market trends:

– Reinsurance downside risks grow, June renewals will test: Moody’s.

– Consolidation ahead for smaller reinsurers: Munich Re CFO.

– Reinsurance prices to drop by double-digits at June renewals: Fitch.

– Alternative reinsurance capital grew 28% to $50 billion in 2013: Aon Benfield.

– Capital market threat could be reinsurance game-changer: A.M. Best.

– Watford Re, and start-ups, a blank canvas for reinsurance innovation.

– Reinsurance renewal prices fall by as much as 20% across sector.

– Alternative reinsurance capital to grow to $100 billion: BarCap.

– Will Lloyd’s look to embrace third-party reinsurance capital?

– Munich Re on competition and alternative reinsurance capital.

– Munich Re: Reinsurance market competitive as capital spills over.

– Zenkyoren sets the tone for April reinsurance renewal pricing.

– April’s reinsurance renewals to show alternative capitals influence.

– Traditional reinsurers challenged to compete on cost-of-capital .

– Willis warns reinsurers to stay relevant in a market in flux.

– Capital creates competition in casualty reinsurance, where next?