The entry of alternative capital into the reinsurance market and the growth of ILS is not just expected to continue to disrupt the traditional market, it is expected to have a “profound and lasting effect” according to Fitch Ratings.
The growth of alternative capital and the increasing use of insurance-linked securities (ILS) instruments such as catastrophe bonds and reinsurance sidecars, alongside the growing acceptance of insurance and catastrophe risks as an asset class, has all resulted in a reshaping of the reinsurance landscape.
The first effect has been the pressure on reinsurance rates in certain specific areas of the market such as U.S. property catastrophe risks.
Fitch Ratings Senior Director Martyn Street commented during a briefing in London last week; “Declining premiums rates are being exacerbated by the growth of alternative capital.”
“It continues to grow in certain parts of the market, particularly in some of the North American property catastrophe lines and we believe that it will have a profound and lasting effect on that part of the market,” he continued.
Street and Fitch Ratings expect further growth of ILS; “Alternative capital capacity will continue to impact the market. We continue to see private equity, hedge funds and pension plans going into the space, attracted by higher yields, as yields generally remain under pressure.”
While Fitch expects further growth for alternative capital and ILS, it notes that the rate has slowed. “ILS pricing has stabilised and is disciplined with the spread between ILS and high-yield bonds compressing to 100bp,” Street noted.
Street said that this signifies that investors could have a reduced appetite for reinsurance risk at the current low pricing, which could result in ILS moving down the reinsurance program tower a little. This “could provide a floor for reinsurance pricing,” he noted.
Fitch views the entry of alternative capital and its growth as profound, being a major cause of the structural change we see in the reinsurance market today. As a result the rating agency expects to see reinsurers making further attempts to embrace alternative capital or adapt to it.
“Our view is that this is a permanent feature, so this isn’t something that is going to reverse. I think there is a growing acceptance across the market that this is a permanent change and something that needs to be addressed and adapted to,” Street explained.
During his comments at the London briefing Street explained that the reinsurance market is facing “structural change being created by the ingress of alternative capital,” one of the results of which is the pressure to acquire scale or diversification.
The reinsurance companies that are most exposed to the growth of alternative capital are some of those most pressured to search for M&A opportunities, Street said. Although Fitch remains unsure of the value being created by some M&A deals.
The rating agency sees a trend where, overall, the percentage of property catastrophe limits underwritten by ILS players and alternative capital is growing as a share of the business line.
The expectation is that a slower rate of growth and penetration by alternative capital will over-time be seen in other re/insurance business lines and even directly in primary risks, as investors appetite for the asset class drives them to disrupt the insurance value chain even further.
Street continued; “At least part of the attraction for this money is the high yields that are being achieved within the space. This is money that would be traditionally invested in other parts of the economy, away from the reinsurance space. But because of the low yields in those other asset classes it is attracted to the reinsurance space.”
However, despite this demand from investors, there is discipline being shown and a clear level of risk appetite is emerging among the ILS fund managers and the sectors end-investors.
“It appears that prices for cat bonds reached a bottom in 2014 so coupons in issuances in the first-half of this year were modestly higher,” Street said. “That demonstrates that investors are willing to take on more risk as long as they are compensated for it.”
This suggests that we could see higher risk layers of reinsurance and retro programs coming to the ILS market in the form of catastrophe bonds in the future, as investor demand will likely dictate issuance to a degree.
“There was a concern that prices had been on a downward trend and were just going to continue in that direction. There seems to be a rationale within the market that actually investors aren’t willing to accept risk at any price,” he continued encouragingly.
With the reinsurance market still adapting to the entry of alternative capital and the growth of ILS, while further innovation and inflows of capital are likely to drive the structural evolution even further, Street said that ILS will have an opportunity to grow to support traditional companies as well.
He discussed the fact that another pressure reinsurance firms face currently, and likely increasingly into the future, is regulatory burden, with the costs associated with meeting enhanced regulatory capital requirements essentially lowering capital efficiency.
That perhaps suggests an opportunity for alternative capital and insurance-linked securities (ILS), as these tools can be used to offset some capital needs, using third-party financing, or transfer certain risks which have higher capital charges attached to capital market and ILS investors.
That could translate into a potential source of additional growth for ILS players and the capital markets, to create products that target assisting traditional insurers or reinsurers to improve or enhance their capital positions and better navigate the changing market environment.
We’ve discussed the need for traditional and alternative reinsurance capital to find a level at which they can co-exist and support each other and the growth of the global insurance market. As profound and lasting changes occur, as Fitch Ratings predicts, the need to find this equilibrium increases.