Alternative capital’s stickiness signals “structurally lower returns”

The expected staying power of ILS, alternative and third-party reinsurance capital signals “structurally lower returns” for reinsurers, but should also eliminate some of the volatility and tail risk in the traditional market, according to forecasts from analysts.

Analysts from RBC Capital Markets said that their outlook for 2015 is for a reinsurance market with lower returns, as alternatives and insurance-linked securities (ILS) specialists continue to display their low cost-of-capital.

Returns required by alternative capital players are typically lower than those historically sought by traditional reinsurance companies. This, alongside the surplus of capital that the traditional reinsurance market is suffering from and insipid demand from reinsurance buyers has lowered the cost that can be charged for property catastrophe risks in the well-modelled peak peril zones, the analysts explain.

Catastrophe lines are now pricing at multi-year lows, as a result of these converging trends, but the analysts at RBC see a pricing floor approaching, saying; “We expect pricing in property catastrophe reinsurance to bottom out towards the middle of 2015.”

However the growth of alternative capital and ILS is leading to a “structural shift” in the non-life reinsurance market, with the potential for this shift to have knock-on effects in the primary market where some commercial lines now show signs of softening.

The new capital is expected to remain in the reinsurance industry, the analysts explain, which signals “structurally lower returns but eliminating some of the volatility and tail risk from the traditional space.”

As a result of this structural shift the RBC Capital Markets analysts expect to see a continued move towards longer-tailed lines of business by traditional incumbents seeking to avoid the most softened areas of the property catastrophe market.

The analysts note that they find this strategy “a risky move” as longer tailed lines have not always resulted in attractive returns and can result in higher underlying combined ratios. “To produce good returns in this business, the industry must estimate future losses well and also rely on investment income to a certain extent,” they explain.

Similarly, efforts are expected to ramp up to target emerging markets, particularly Asia which is seen as the “engine room of growth”, in order to deploy capacity at more attractive rates. However the reduction in demand from large primary insurers has not helped and while emerging markets are expected to help, the analysts do not believe this will be sufficient alone “as the bulk of reinsurance is written in developed markets.”

In terms of the softening of the market, the RBC analysts note that non-life is still heading south and while reinsurance trends are noted as “negative” the analysts suggest that this is with “greater pressures than consensus expectations,” in their view.

Alternative reinsurance capital is expected to continue to grow in size and stature in the market, the analysts continue, as long-term investors still find the space attractive even at lower rates.

However the analysts do warn that if rates continue to fall much further some investors may stop entering the ILS space, as they believe the capital to be “highly return orientated.”

ILS and alternative capital is also expected to continue its penetration of new perils and regions, but the RBC analysts do not expect this capital will “meaningfully enter either primary lines of business or longer tail lines of reinsurance or insurance.”

Reinsurance has “benefitted from strong results in recent years,” thanks to low catastrophe losses and a growing capital base. However, “This super normal creation of profit has exacerbated the level of capital in the industry which has far exceeded the level of growth in World non-life insurance premiums.”

It remains apparent that one of the key issues facing reinsurers with excess capital and also ILS managers who would like to grow more rapidly and accept all the capital their investors would like to allocate in the sector, is finding something to do with this superabundant risk capital.

However with the reinsurance sector still facing structural change, as a result of the shift in its capital base to include the capital markets and ILS, it may take some time for those opportunities to present themselves in such a way as the incumbents can take full advantage of them.