The inflow of alternative reinsurance capital from third-party sources such as pension funds and hedge funds could lead to a doubling in the global property catastrophe reinsurance capacity provided by capital markets investors within a few years.
So say the U.S. non-life insurance equity research team at Barclays Capital Inc. in a research note published two days ago. The Barclays Capital research team highlight the increased competition in the property catastrophe reinsurance market, which is partly as a result of the inflow of capital from non-traditional and alternative sources.
The researchers say that the impact on pricing is unlikely to abate anytime soon, suggesting that the price environment we’re seeing across reinsurance may be with us for some time.
This trend, of alternative capital entering the reinsurance market seeking access to the returns of the property catastrophe market, is seen as structural not cyclical by the Barclays Capital researchers, a point Artemis wholeheartedly agrees with and has written about a number of times before.
This is one of the key points in the research note, that the trends we are witnessing in reinsurance capital and pricing are part of a structural shift which will fundamentally change the reinsurance market as we know it. We are not just witnessing the effects of the typical reinsurance market cycle, rather capital, in abundance from both traditional and alternative sources, has flattened the cycle and we may not see the old trends return.
The researchers highlight that alternative reinsurance capacity has roughly doubled since 2008, currently sitting around the $50 billion mark which is approximately 15% of the global property catastrophe reinsurance market at this time. Barclays Capital expects this growth trend will continue, highlighting catastrophe bonds upsizing despite declining yields as a sign of the continuing strong appetite from investors.
Barclays Capital’s research team anticipate that alternative reinsurance capital as a percentage of the global property catastrophe reinsurance market could double within the next few years. That would mean a doubling of the capital available to around $100 billion which would be equivalent to approximately one-third of the property catastrophe reinsurance market worldwide.
Given reinsurance remains a highly attractive asset class to pension funds and hedge funds, who appreciate the returns, the diversification and the low-correlation of an insurance linked investment, we could see pricing worsen even more, as more capital seeks to enter the space, says the report.
The researchers point out that expected return on equity for the property reinsurance space is actually among the lowest in a decade, as pricing is back at pre-Katrina levels while interest rates remain at record lows. This makes the expected return profile of the sector very low and it could go even lower as capacity continues to outstrip reinsurance demand.
The report does not forecast a complete takeover for alternative reinsurance capital, saying that is unlikely to displace traditional reinsurance entirely, partly because there remains a concern about how sticky the new and alternative capital is.
At the same time the report does say that an influx of additional capital from third-party sources after a major catastrophe event may soften the cycle and remove price spikes after events. The researchers expect that this could help to drive consolidation among Bermudian reinsurers, particularly the property catastrophe companies with lower RoE’s.
The reinsurance survivors, say the researchers, are likely to be the largest reinsurers which also benefit from managing third-party capital, such as RenaissanceRe and Validus, or the globally diverse reinsurers such as Munich Re, Swiss Re and their peers.
The researchers provide three scenarios for the growth of alternative reinsurance capital and the implications of each for traditional reinsurers. As you might expect, all three have negative connotations for some reinsurers, especially the property catastrophe focused, which are not already embracing alternative capital or which have only just launched capital markets units.
Scenario 1 – Most likely scenario
This scenario suggests that alternative capital doubles in size, the most likely result of continuing interest in reinsurance as an asset class from capital market investors, explain the researchers.
This would create further pressure on returns and top line growth for traditional reinsurers, flatten out the pricing cycle peaks and troughs, and spur consolidation in Bermuda among property catastrophe focused reinsurers which don’t already embrace alternative capital management.
Scenario 2 – Best case scenario
This scenario suggests that alternative reinsurance capital peaks and stabilises at around the $50 billion that is in the market today.
The researchers see this as unlikely as capacity has room to expand, noting that it would be optimistic to believe that alternative capital won’t continue to grow as primary insurers become increasingly comfortable with accessing capital markets backed and collateralized reinsurance capacity.
Scenario 3 – Worst case scenario
This scenario suggests that the traditional property catastrophe reinsurance capacity is wholly replaced with fully-collateralized reinsurance capacity.
The researchers say this is also unlikely, because reinsurance buyers are not yet sure whether alternative capital will recapitalise after a major event. However they note that the size of the global property catastrophe reinsurance market is small compared to global pension fund assets, a common comparison, so it is actually a relatively insignificant piece of the capital available. The researchers acknowledge the structural challenges to third-party capital replacing traditional reinsurance, but use this example as a demonstration of the potential capital available.
It’s not all bad for reinsurers though and the researchers point out that third-party reinsurance capital management presents an opportunity to acquire fees, increase scale and flexibility without having to bring more catastrophe risk onto their balance sheets. The lower cost-of-capital associated with alternative capital could also benefit some reinsurers and help them to broaden their underwriting scope as well.
The researchers note that 2014 looks set to bring more challenges for traditional reinsurers, with no sign of the trend towards a growing alternative reinsurance capital market slowing and pricing pressure set to continue.
The Barclays Capital equity research team are just the latest to issue a note acknowledging the pressure traditional reinsurance firms are facing from alternative capital. As a result, the investors who buy the equities of property catastrophe focused reinsurance firms will likely become increasingly aware of these trends. Share volumes in some reinsurers suggest there has been a lot of churn in their investor base already this year.
That is a trend that is likely to continue. The clients of these equity researchers are often large, sophisticated investors, such as hedge funds, who have been allocating capital to insurance and reinsurance stocks for many years. These investors ask intelligent questions and when their bank’s research team provides them with research suggesting the sector they invest in is undergoing structural change they are likely to sit up and take notice.
As the sentiment on traditional reinsurers continues to drag, how long will it be until these investors begin to look at how they too can access reinsurance as an asset class more directly as well? That could simply result in even more capital being attracted to the insurance linked investments space, but of course also presents savvy reinsurers with an opportunity to switch what were once shareholders into third-party capital providers. That could be an interesting trend that emerges behind the scenes.
Hat-tip to Mark Hofmann at Business Insurance for alerting us to the research note.