Alternative reinsurance capital, in the form of collateralised products such as catastrophe bonds, industry loss warranties, sidecars and collateralised reinsurance contracts, is growing faster than traditional reinsurer capital and has made an “indelible footprint” in the market, says Standard & Poor’s.
The growth of third-party capital, or alternative capacity from insurance-linked securities (ILS) funds and the convergence market, continues to grow rapidly, albeit at a slower rate than seen in recent years, S&P explains in a new report.
Alternative capital has more than doubled its participation in property and casualty reinsurance, largely in property catastrophe risks, rising from a 5.4% market share in 2007 to a 12.8% market share in the first-half of 2016, the rating agency says.
“The convergence market is still relatively young, certainly appealing, but remains untested, most notably by tail events that could trigger significant losses,” commented S&P Global Ratings credit analyst Taoufik Gharib.
This wave of innovative capital has left “an indelible footprint in the property casualty reinsurance sector” according to the report. S&P asks the questions of whether this will continue and whether ILS will further expand its reach into the global reinsurance sector.
The answers to such questions depend on factors such as the risk appetite of investors, the size and impact of natural catastrophe losses in the future (or indeed the lack thereof), how debt capital markets perform, where interest rates move, and of course the unmodelled losses and their magnitude.
In response reinsurance companies have been establishing their own vehicles to harness alternative or third-party capital, but S&P warns that while these efforts could benefit reinsurers, they “may gain strategic benefits by increasing their market footprint while earning more fee income” but they warn that “fee income will not compensate for lost underwriting profits.”
The threat to reinsurers is that “amplified competition and decreasing pricing have further diminished reinsurers’ margins, making companies’ earnings and potentially their capital more sensitive to large catastrophe losses than in previous years,” S&P continues.
This puts the more marginalised and mono-line reinsurance companies at the greatest risk that, “their competitive position weakens, which could ultimately have a negative effect on our financial strength ratings.”
On the other hand, companies that can leverage this new capital for their own risk transfer needs and who can benefit from the efficiency of capital markets capacity benefit from “lower premium rates, a more-diversified source of reinsurance capacity, and the ability to place larger reinsurance programs.”
Recent catastrophe bond transactions are a case in point, sometimes offering cheaper capacity than traditional reinsurance programs, which S&P notes gives the brokers a much-needed bargaining chip when it comes to renewals.
S&P explains; “We have continued to see larger cedants become more comfortable with replacing some of their traditional reinsurance program layers with catastrophe bond issues for diversification and pricing advantages. These larger cedants are more likely to purchase reinsurance based on the risk/reward trade-off and generally place less value on longer-term partnerships.”
The need to adapt and come to terms with this trend are clear and S&P notes that most traditional companies are getting to grips with third-party capital and ILS, using it within their own reinsurance programs and managing it, or underwriting for it, in order to access a new source of fee based income.
This can allow traditional companies to maintain a larger presence in the reinsurance market, leveraging the appetite of institutional investors to access the insurance-linked asset class as a source of return with little correlation to wider financial market happenings.
S&P notes that the ILS and collateralised reinsurance product set is being made increasingly appealing to the market, by more closely matching the traditional reinsurance product.
Additionally the collateralised nature of the ILS and alternative market products is attractive to ceding companies, as the have little counterparty risk compared to risk being held on an equity balance-sheet.
The attractiveness of ILS and alternative capital products has helped the sector to outgrow traditional reinsurance capital, which has in fact shrunk due to reinsurers returning capital to investors as they cannot deploy it profitably.
The fact that ILS grows still, albeit at a slower rate, is testament to the efficiency in the product and the fact that lower-cost business models enable capacity to be offered at highly competitive rates.
Growth could have slowed partly because investors are watching for other yield opportunities, such as through the expectation of gradual but steady increases in U.S. interest rates. However, the market factors of softening and the availability of profitable underwriting opportunities likely have as large a bearing, we would venture.
The resulting tightening of spreads, influenced by broader softening in reinsurance markets and the ensuing competition, may have helped to slow growth.
S&P notes that on cat bonds in particular; “Future investor appetite for catastrophe bond exposure, while still strong, may not be as aggressive. A tighter yield may slow the buying frenzy surrounding catastrophe bonds.”
As the market has developed and ILS capital has become a meaningful piece of overall reinsurance capital, the ILS funds have become more specialised and this could result in greater innovation and an ability to out-gun the traditional market.
It also means that; “As new entrants with the need to deploy their investors’ capital, ILS funds may be more flexible in offering cedants products that have been difficult to obtain from traditional reinsurance carriers.”
However, S&P is still bullish on the ability of traditional reinsurers to remain competitive, to produce products that target areas that ILS is perhaps not so suitable and to collaborate with third-party capital to make themselves more effective.
“Traditional players retain many advantages over newer alternatives,” S&P says. “Traditional reinsurers have a more-permanent capital structure and tend not to change entire business models.”
The use of third-party capital vehicles such as sidecars may actually help forward-thinking reinsurance firms to enhance their own product-offering, S&P explains. If utilised for the risks that the capital markets are most suitable, it could free up the balance-sheet to work where it is best put to work, making the adoption of ILS as a secondary balance-sheet a proactive move in the face of a challenging market environment perhaps.
S&P warns though that ILS is still untested, when it comes to a major market-wide loss event and that this could have ramifications for the availability of reinsurance capital when the next really major loss occurs.
“Because investors could suffer total losses from a catastrophe on many convergence-market investments, their reaction may be more severe than expected, especially if multiple bonds are triggered by a single event. To the extent that capital flows induce more-liberal risk assumption, there’s a greater chance that investors could be surprised when significant losses actually occur,” S&P suggests.
But while untested the ILS market offers opportunity and the traditional reinsurance space can make use of it to enhance their product, enable them to offer new coverages and to deepen their activity in areas where the balance-sheet is not as well-suited.
The growth of ILS remains very much a case of a threat and an opportunity for the reinsurance market. Forward-thinking companies are embracing this, rather than retreating, and it is those who gain experience and comfort, as well as a track record in managing third-party money, who stand the best chance of profiting from this wave.