Convergence capital, the “new norm” for reinsurers to stay competitive: S&P

Third-party reinsurance or alternative capital has become a “new norm” for reinsurers as they seek to remain competitive, meaning that so-called convergence capital from the insurance-linked securities (ILS) market will remain key.

Despite falling for the first time in 10 years, the use of ILS or convergence capital by insurance and reinsurance firms has become increasingly strategic and embedded within their business models.

This has led rating agency S&P Global Ratings to call ILS capital “key” explaining that the use of third-party capital, particularly by reinsurance firms, should be considered a “new norm” as it is incorporated into their operations to help them remain competitive.

In a new report, S&P explains that after the dip seen in ILS capital following the losses of recent years, the inflows to ILS funds and other collateralised reinsurance vehicles have continued, although at a slower rate.

S&P notes the flight to quality, the well-documented ability of the more established, largest and best performing ILS fund managers to continue attracting capital, explaining that, “we believe capital will continue to flow into the market, particularly to insurance-linked security (ILS) funds with strong underwriting, established track records of successful capital deployment and transparent reporting.”

Overall the rating agency says that it expects that, “convergence capital will continue to play an important role in the competitive dynamics of the global reinsurance market and bolster capacity.”

While traditional reinsurance firms will increasingly, “factor third-party capital into their strategies to help them respond to the ongoing challenging competitive environment.”

S&P highlights that investors have shown some reluctance to enter the ILS market, or to reload their allocations to reinsurance linked investments following the major catastrophe loss years.

This is “not surprising” S&P says, following the two worst performance years for ILS and catastrophe bond investments since the market’s inception.

In addition, 2019 returns have been depressed by the continued impact of prior year losses and loss creep, as catastrophe loss events such as typhoon Jebi and hurricane Irma/Michael continue to develop.

But even taking into account the catastrophe losses and loss creep suffered by ILS investors, “new capital has entered the market–albeit at a slower rate,” S&P explains.

But the focus of investors has sharpened, S&P continues, saying that “the recent losses have put investors’ focus on seeking out the best available returns.”

S&P believes that enhancements to models and adjustments to contract language, such as peril exclusions, will encourage further growth of the ILS market over time, once the recent losses are settled.

“Many third-party capital investors have made good returns over the long term, and the argument for investing in insurance risk to achieve portfolio diversification remains valid,” the rating agency explains.

Adding, “For cedants, this means that there is capacity for the right risks at the right price.”

The collateralised reinsurance segment of the market has demonstrated that “convergence is truly underway,” S&P notes.

“All players continue to innovate and explore different routes and solutions to gain access to capital or insurance risk in the most cost-effective manner,” S&P continues, trends that are developing very quickly as new start-ups are set to demonstrate in months to come we would add.

Rated reinsurance vehicles is one route to market that is more direct and efficient, as too are initiatives that seek to bring ILS capital closer to pools of directly originated risk.

Insurer and reinsurer owned third-party capital vehicles are perhaps where the greatest level of convergence is seen, as here the capital markets are directly integrated into the traditional business model as augmentation to the re/insurers own balance-sheet capacity.

“These platforms help insurance and reinsurance companies attain greater scale and relevance as well as target lines of business where the returns might not support their own cost-of-capital adequately, which would allow them to provide more complete solutions to their clients,” S&P explained.

In the past, traditional reinsurers viewed third-party capital as a “nice to have” S&P says.

But now, “It has become the new norm, with established players incorporating third-party capital into their operations to stay competitive.”

S&P further explains that in analysing reinsurers for rating purposes it looks closely at the businesses risk profile, with its competitive position compared to peers a key factor in this.

Typically, a company with a stronger competitive position is expected to exhibit consistently higher and more stable profitability metrics than peers, S&P explains.

Leading it to say, “Using third-party capital to profitably grow the top and bottom line should, in general, reflect positively on this assessment.”

That reflects the rising importance of having access to third-party capital and owning the deployment of it for reinsurers.

But, we would again note that it has yet to be proven out how this strategy will play out for all reinsurers, as they look to juggle own balance-sheet shareholder capital with that raised into reinsurance vehicles and ILS funds they own.

Is the fee income and profit share that can be earned by underwriting using third-party capital really a sufficient replacement for the profit earned by underwriting using a reinsurers’ own balance-sheet?

Or will it be proven in time that the use of increasing amounts of third-party capital will force the need for increasing efficiency and lower expenses on reinsurers?

In addition, the questions of conflicts of interest remain and have not been answered to the satisfaction of many investors, who find allocation decisions by reinsurer owned ILS vehicles and funds often difficult to understand, largely because the explanations for decisions are often not particularly well-articulated.

While some players seem to be managing this juggling act adequately for now, it is going to take time for the industry as a whole to establish just how successful this will be across the sector.

Questions also still exist about what will happen if rates continue to rise, so reinsurers decide their appetite for catastrophe risk on their own balance-sheet has increased?

Will they continue to feed their third-party investors at that point in the cycle and how will allocation decisions (to the different forms of capital) change at the same time?

The crux of this is that reinsurance is still evolving and the market adapting to the availability of capital market financing, the use of financial market technologies such as securitisation, and the emergence of the ILS investment market.

In addition the use of data and technology is going to change the playbook again for re/insurers and ILS fund managers alike in years to come, with the evolution and disruption we’ve seen so far likely to be eclipsed by what comes next.

Yes, convergence continues, looks set to be sustained, will likely accelerate and has certainly become a “new normal.”

But at the same time, it remains early days in this evolving world of reinsurance and risk transfer, with the winners and losers yet to be fully identified.

Which all means there is plenty of room for change and for new strategies to emerge, as the traditional insurance and reinsurance market continues to converge with the growing sources of third-party capital.