Hybrid balance-sheet, the future of reinsurance

Reinsurance firms operating with a hybrid balance-sheet approach to capital sources, management and funding, are the future of the industry, according to speakers at the SIFMA IRLS 2016 conference in New York.

Speaking at the event on a panel discussing how alternative capital and insurance-linked securities (ILS) feature increasingly as tools available to help reinsurance companies better manage their capital and enhance their cost-of-capital, executives pointed to the likelihood that companies take an increasingly agnostic approach to form and structure.

Aditya Dutt, President of Renaissance Underwriting Managers Ltd., the unit that deals with third-party capital, ILS and joint ventures at Bermudian reinsurer RenaissanceRe, said that he sees hybrid balance-sheets as the future.

“We’ve clearly subscribed to the hybrid model,” Dutt explained, adding that RenaissanceRe embraces both third-party and equity capital and that it was an “evolution” in the business model that was driven by what the reinsurers clients actually wanted.

In a market environment where reinsurance companies have come under increasing pressure, as the industry evolves towards one where cost-of-capital and capital efficiency increasingly matter, welcoming third-party capital into the capital structure is becoming vital for reinsurers.

“The reinsurer of the future” will look like this, Dutt explained. The hybrid capital balance-sheet, where more traditional equity capital and debt play equally alongside alternative capital from sources such as collateralised reinsurance, sidecars, catastrophe bonds and managed funds.

This evolution, as Dutt called it, is also seeing reinsurers becoming more like ILS fund managers, in many ways, managing portfolios for large institutional investors and bringing third-party capital right alongside their own balance-sheet capital, as a complementary funding and risk financing tool.

Complementary was a word used by Craig Redcliffe, a Partner in EY’s Insurance practice.

The permanent debt and equity capital of a traditional balance sheet, “is that really an efficient model for a reinsurer” Redcliffe questioned.

This capital can have a large drag on traditional reinsurers, from an ROE perspective Redcliffe said, adding that it makes active capital management more difficult due to constraints such as regulation and ratings.

Redcliffe implied that third-party capital structures can allow reinsurers to be more nimble and to have a more flexible approach to managing their capital and business.

He added that it is all about efficiency, with those embracing multiple balance-sheets “matching risk to the most efficient form of capital.”

“Just in time capital” could be argued as the most efficient form of capital, Redcliffe said. He noted that there are again constraints to operating in this way, but it is interesting as we know that some investors have contracts with managers and reinsurers to allow them to deploy more capital when opportunities arise, which truly is “just in time capital,” as Redcliffe termed it.

Taoufik Gharib from Standard & Poor’s said that alternative capital can give reinsurers an added degree of “financial flexibility,” something that companies need in the current climate.

The ability to elect which capital to use for which underwriting, or growth, opportunity is becoming vital for traditional companies. Even the very largest reinsurers are achieving this, either through leveraging ILS and cat bonds, or fronting for ILS funds, or providing stop loss type products to collateralised reinsurance deals.

Dutt from RenaissanceRe said that at his firm there is less distinction between products and more focus on getting the right capital in front of the right clients, or deployed into the right underwriting opportunity.

The traditional rated balance-sheet is the natural and more efficient home for a diversified portfolio, while the “ILS balance-sheet is the natural home for a more concentrated portfolio,” Dutt said.

Reinsurers are looking and feeling increasingly like asset managers with a rated balance-sheet as well, and participants in the SIFMA event panel did not think the traditional balance-sheet would go away. They highlighted constraints in the permanent balance-sheet model, which allows those adopting a hybrid approach to benefit from greater efficiencies.

This efficiency allows reinsurers to better navigate the softened reinsurance market cycle, take advantage of opportunities, leverage the capital markets for retrocession or as a companion in their underwriting. This all helps to improve the cost-of-capital and efficiency of underwriting capital.

As a result of this trend towards a hybrid reinsurance capital model, new structures are expected to emerge. As reinsurers follow down this path, there is perhaps also a chance that more insurers will do so as well, seeking to welcome alternative capital into their business, as has been seen with internal reinsurance vehicles and partnerships in recent years.

All of this bodes well for the ILS investor base, as they will gain even more access to risk and become increasingly welcome within a reinsurers capital structure. That will grow the ILS market’s capital base even more quickly and with the pressured market remaining a feature, efficiency is becoming so important that it’s hard to think any reinsurer can avoid embracing a hybrid, multiple balance-sheet model for much longer.