S&P answers investor questions on alternative reinsurance capital

It’s always informative to read what the leading rating agencies have to say about the continuing convergence of reinsurance and the capital markets. Standard & Poor’s provides some of its thoughts on alternative reinsurance capital in a recent publication.

The report contains Standard & Poor’s answers to questions posed by investors about the current state of insurance and reinsurance markets. In the report S&P answers queries about why it recently revised its outlook on the reinsurance sector to negative., what the chances are for reinsurance mergers and acquisitions in 2014 and whether alternative capital is here to stay.

These are the questions that Standard & Poor’s has received from investors, along with its answers, which are most relevant to the topic of reinsurance convergence and alternative reinsurance capital.

Why did Standard & Poor’s change its outlook on the reinsurance sector to negative?

The tipping point came in early January, when we observed increasingly competitive behavior among reinsurers that we believe will weaken profitability in 2014 and 2015. We think that companies without a defendable competitive position, or those that are more aggressive in maintaining market share by competing on price or relaxing their underwriting discipline, are most at risk. If we observe these competitive forces at work in a reinsurer’s product mix or risk profile, we could revise our assessment of its business risk profile to reflect the relatively higher risk. In addition, we believe reinsurers that display diminished capital buffers, or those that demonstrate ongoing constrained earnings capacity, will face a trying future.

What is your view of reinsurer merger and acquisition (M&A) activity in 2014?

We believe consolidation will rise in importance on the strategic agendas of reinsurance management teams over the next 12 months. For smaller reinsurers that are trying to compete globally, consolidation may be one of the few viable survival options, and midlevel players will be looking to acquire greater size and scope. Meanwhile, book values have climbed in recent years, now averaging 1.1x, so they’ve become more accommodating of M&A activity. Buyers and sellers of reinsurance businesses appear to be placing more emphasis on size as a competitive advantage, as we highlighted in “Pricing Pressure, Profits, Prospects, And New Players: Tension Mounts In The Reinsurance Market,” which we published on Sept. 4, 2013. As reinsurers look to expand their size and scope to meet their clients’ needs, M&A will likely be the most attractive option in an unfriendly market.

Is alternative capital here to stay in the reinsurance sector?

Alternative capital, in the form of insurance-linked securities (e.g., catastrophe bonds, industry loss warranties, and collateralized reinsurance), sidecars, and catastrophe funds, has been part of the reinsurance landscape for decades. However, over the past couple of years, the influx has increased significantly. As much as $100 billion of alternative capital will likely flow into the reinsurance market during the next five years, according to reinsurance intermediary Aon Benfield. Some of the investors behind alternative capital are long-term strategic institutional investors (such as pension funds) that we believe have well-thought-out investment strategies and are likely to stick around longer than more opportunistic investors (e.g., hedge funds). We would expect that when yields on traditional asset classes return to long-term historical norms, some of the opportunistic investors would retreat to more conventional investments. In addition, the staying power of these opportunistic investors has not been fully tested by a major natural catastrophe.

In general, reinsurers are trying to harness alternative capital to improve their value proposition and lower their cost of capital. However, it’s not beyond the realm of possibility that a reinsurer could effectively become a conduit for passing risk from the insurance industry to the capital market, which would significantly undermine the reinsurer’s competitive position.

That last comment made by S&P, that reinsurers could become conduits for moving risk from insurers to the capital markets, is particularly interesting and perhaps insightful. There are signs that some smaller reinsurers could find themselves increasingly moving in this direction.

As Artemis has written before, if recent trends continue to accelerate we could see a time where an ILS player seeks a rating and transforms into a reinsurance company, while a traditional reinsurer could return all its equity capital and become purely backed by the capital markets.