Traditional reinsurers are trying to establish the ‘modus operandi’ of alternative, or third-party, reinsurance capital, as they attempt to work out the optimal response to its growing influence and the increasingly important role it plays in the global reinsurance market.
Reinsurers have seen the influx of capital from institutional and capital market investors during the year, watching third-party capital take an ever larger slice of property catastrophe reinsurance programs, as cedents and brokers put its inherent efficiencies and lower cost of capital to work.
Executives and credit analysts discussed whether alternative reinsurance capital should be seen as a friend or foe by reinsurers at the recent Bermuda Reinsurance Conference, held by Standard & Poor’s and PwC. Mostly the response is that the influx of capital from third-party sources is positive but, S&P notes, with caveats.
Insurance-linked securities, catastrophe bonds, sidecars, collateralized reinsurance, industry loss warranties, all backed by capital from third-party investors, are taking an increasingly large slice of what was once prime business for traditional reinsurers. This capital has been around in these forms and others for almost twenty years, but the last eighteen months has seen an acceleration of the trend as investors in search of yield with low correlation to wider financial markets.
Rodney Clark, managing director at S&P and moderator of a panel discussion at the event, explained that many reinsurance market participants view third-party capital as a threat to their core business and question whether it is a friend or a foe of the reinsurance market. “I suspect what we’ll find is that it’s a little bit of both,” he commented.
One participant at the event, Aditya Dutt SVP at RenaissanceRe Holdings Ltd. and president at Renaissance Underwriting Managers Ltd., long-time users of alternative capital, sees it as an important diversified source of capacity. “It was a strategic imperative a long time ago,” he explained. He said that it “absolutely informs our strategy but doesn’t change what we’re doing.” Dutt explained the many benefits alternative capital has for his clients, including keeping the cost of capital low, explaining that “one source of capital may not be enough.”
Beat Holliger, managing director at Munich Re Capital Markets, agreed that third-party capital can help to keep costs down due to its lower cost of capital, while enabling the transfer of risk from equity balance sheets into the capital markets. “Overall, it’s more friend than foe,” Holliger said.
On the much-discussed topic of whether capital from investors such as pension funds would be sustainable and stick around after large loss events, Holliger explained that it is a “pretty sustainable situation that we have now.”
Holliger notes that pension funds began to enter the insurance-linked securities (ILS) space back in 2008 and over the years it has been involved in the space has got comfortable with the risks involved. “I don’t think a capital loss will make them withdraw their money,” he explained, citing losses in 2011 which did not make capital withdraw. “You expect to lose money at some point with these bonds; if these events don’t happen four or five times in a year, you’re fine. That’s why we think the capital will stay in this market.”
One area that Holliger said the impact from alternative reinsurance capital will be noticed is in the underwriting cycle. He said that the “underwriting cycle will get shorter,” as a result of the influence of lower cost capital with the ability to take on risk more cheaply.
On the topic of what might cause capital to flee the ILS and reinsurance space, Dutt from RenaissanceRe explained that it is the unknown or unexpected that is likely to cause the most concern among investors. Discussing September 11 as an example Dutt said; “Some of the smartest investors in reinsurance are pulling money out. They lightened up or they’re flat.”
September 11 was unpredictable, Dutt explained, which makes investors nervous. “That’s what scared people off; it’s something that changes the market that causes both reinsurers and capital to exit really fast. What happens if a really big event happened in China, and the Chinese buy up a ton of reinsurance? That would change the entire market.”
The discussion of whether alternative capital is a positive or negative for reinsurers is likely to become even more vocal after the January renewals, once we establish whether ILS and third-party capital has made further inroads into core reinsurance programs, pushing out some traditional players.
Early indications from the market are that traditional reinsurers are fighting back on both price and terms, as they hope to secure valuable and profitable layers of programs. We understand that a number of catastrophe bonds which are maturing at the end of this year may not now be renewed immediately, due to the price competitiveness of traditional and also collateralized reinsurance alternatives.
This gives the strong impression of a market in search of equilibrium, currently vying for dominance, when in fact the most profitable and sensible way forwards may be to find where different types of capital and different risk transfer structures are the best fit for purpose for both clients and capital.
Reinsurers should perhaps stop trying to characterize alternative and third-party capital as either a friend or foe and instead look to it as a permanent compatriot to their balance sheets, to be used where most appropriate. Otherwise the market does risk entering into a race to the bottom on a price and terms basis. That is a dangerous place to be and not particularly attractive for either form of reinsurance capital or for the investors who provide it.
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