Alternative reinsurance capital poses opportunity and threat to Lloyd’s

The Lloyd’s of London insurance and reinsurance market recognises that the increasing interest being shown by third-party investors in reinsurance as an asset class poses both an opportunity and a threat to the markets future, according to comments in Lloyd’s latest interim results.

The Lloyd’s market announced a profit of £1.38 billion for the six-month period ending 30th June 2013. Gross written premiums increased by 4.9% to £15.5 billion. However, despite a benign six months for natural catastrophes, with no major claims impacting Lloyd’s, total net claims were still £4.85 billion resulting in a combined ratio of 86.9%.

The biggest negative for Lloyd’s in the first six months of 2013 was the interest rate environment which it blamed for low investment returns of just £247m for the period. Compare that to a year earlier when it returned £619m for the first half of 2012 and you can see just how low that return was, although still positive in a difficult economic environment.

Much has been made of recent comments by the Lloyd’s Chairman regarding alternative reinsurance capitals growing importance in the market. The commentary from Lloyd’s has ranged between warning of impending systemic risks due to alternative capital to extolling the growth opportunities it will present.

In the interim report statements Lloyd’s representatives said that alternative capital presents both an opportunity and a threat to the Lloyd’s market.

Lloyd’s chairman John Nelson commented on the two main threats to the market; “The first is that we should expect investment income to remain subdued. The second is the volume of capital, particularly from outside the industry, which is seeking to gain exposure to the insurance sector. This is putting greater downward pressure on premium rates.”

This downward pressure on rates is beginning to be felt across the Lloyd’s market and is moving into new lines of business where alternative capital has yet to really penetrate. The knock-on effect of cheaper rates could snowball across the market, it may force reinsurers to move into new lines, increase competition and alternative capital itself may look to move into areas that Lloyd’s has specialised in, this is likely what Lloyd’s is particularly afraid of.

However it’s not all bad and Lloyd’s does see the opportunity that alternative capital presents. Nelson said; “In the longer term, however, harnessing the increased availability of capital to the longterm growth expected in specialist general insurance – caused by the growth in emerging countries which currently have low insurance penetration levels and the changing nature of business risks – will be important for the Lloyd‘s market.”

Lloyd’s is clearly trying to find ways to embrace alternative capital as well, something the market was actually built on with the backing of private Names and external money. Nelson continued; “This subject is attracting considerable debate within the industry and the Corporation is focusing carefully on these issues for the Lloyd‘s market.”

Of course it’s not just alternative capital that Lloyd’s is feeling the pressure from, there is also the small issue of the Aon and Berkshire Hathaway sidecar full-follow facility which has created some consternation in the market as well as Warren Buffet’s move into excess and surplus lines in the U.S., again through Berkshire Hathaway. All of these factors contribute to concerns about Lloyd’s growth potential.

The interim report says; “The new broker distribution initiatives, increasing capital market convergence and the arrival of a high-profile new entrant in the US Excess and Surplus lines market may make material premium growth at Lloyd’s more challenging.”

The Council of Lloyd’s is also concerned and recognises the potential threat posed by alternative reinsurance capital and new broker facilities on the market. Work is being undertaken to attempt to mitigate the risk it says; “As part of the ongoing risk and control process, the Council considers that due to the increased use of broker facilities and the influx of non-traditional capital market products into the industry, there is potential future risk to the flow of business into Lloyd’s. A range of actions are underway to investigate and mitigate this risk, co-ordinated by the Risk Committee and with significant input from the Franchise Board.”

If Lloyd’s really wants to mitigate the impact of alternative capital on the market why not fully embrace it? Lloyd’s itself could establish a new central fund for external capital, which is only used to grow premiums, not cannibalise existing ones, with capital provided by external investors.

Having a new pool of capital available could help Lloyd’s take a larger slice of the marketplace, meaning more opportunity for everyone. Third-party investors would love this as it would give them a highly diversified reinsurance-linked investment.

Of course such an idea would not prevent the pressure on rates, but if investors such as pension funds are really here to stay and their interest in insurance and reinsurance as an asset class is truly destined to move firmly outside of catastrophe risk, then Lloyd’s will need to find a way to embrace that.

Otherwise someone else could establish a new insurance and reinsurance market, with a central fund provided by pension funds and other third-party investors, with underwriters participating in the market in a similar fashion to syndicates. This alternative capital backed re/insurance market could very quickly flood the sector with capacity, write business across multiple lines and then where would Lloyd’s find itself?

Of course that’s an extreme version of the potential end-game of the recent trends in the market and likely unrealistic. But it gives you an idea of the threat being posed by new sources of capital and the importance for entities such as the Lloyd’s market to find ways to embrace and work with it.