Catastrophe reinsurance rates are set to see double-digit declines at the January renewals, against a backdrop of benign loss experience, an accumulation of capital amongst traditional reinsurers and continued inflows of third-party or alternative reinsurance capital.
UK-based equity broking house and analysts Peel Hunt said in its latest report on the non-life reinsurance sector, cleverly titled ‘Cat Flap’, that catastrophe reinsurance prices are set to decline again at renewal time, barring a major shock-loss event between now and the end of the year.
In contrast, Peel Hunt sees a brighter outlook for commercial and specialty lines of reinsurance business. However it does note that there is a risk that alternative capital may be attracted to this area and reallocated from catastrophe reinsurance business, something already evident in the market.
The Peel Hunt report notes that alternative reinsurance capital has been held responsible for triggering steep declines in catastrophe reinsurance pricing at the mid-year renewals, with Florida seeing the steepest decline. The report notes that the lower cost of capital, associated with capital market sourced third-party reinsurance capital, is entirely rational as it seeks a lower return than a traditional reinsurer requires.
Traditional reinsurers have historically sought 10% to 15% return on equity, with 8% to 10% required to cover the cost of capital, where as a pension fund could see a 4% return from a one-year investment in catastrophe risk as a significant uplift over achievable returns from many government bonds.
The report notes that even if interest rates rise, investors in catastrophe risk and reinsurance will benefit from the rate increase on the return of the collateral assets backing the reinsurance risk. This, the report says, led Peel Hunt to believe that this new capital is seeking more than just yield in a low return environment and that it is no surprise it has been attracted by Florida wind risk, with its often 25% to 40% returns, a market which has perhaps been generating excess returns given the availability of data for it.
Peel Hunt sees alternative capital as a sticky and permanent feature of the reinsurance market, explaining that now that pension funds are making up a large proportion of this capital it has a generally more long-term view and catastrophe reinsurance is seen as a strategic asset to allocate capital to.
However, the report notes that third-party capital will not allocate to reinsurance at any price and that the primary motivation for investors is not to drive prices down. This is certainly true and is also the reason why a lot of capital is happy to sit on the sidelines as the insurance-linked securities (ILS) and reinsurance-linked investments market develops, waiting for the next positive movement in rates.
Peel Hunt sees the expansion of the alternative reinsurance capital market into new lines of business as inevitable, citing data, models and intellectual property as key to the markets growth outside of property catastrophe risk. Capital is beginning to find its way into new lines of business, such as marine and energy, but the experience, knowledge and access to underwriting expertise is key to making this expansion sustainable.
Because of this requirement for expertise, Peel Hunt believes that some traditional reinsurers with capital markets units are set to benefit and perhaps be able to expand more readily than dedicated ILS specialists. The availability of historical loss data, risk models and the ability to make informed decisions about underwriting and pricing of risks will be in demand as the market tries to grow.
The report notes that innovation is likely as the ILS and alternative reinsurance capital market continues to develop. Peel Hunt sees the greatest innovation as likely to occur where alternative and traditional reinsurance capital work together, something being seen more frequently among ILS players with traditional parent companies or seed sponsors.
There is little reason, the report notes, to prevent vehicles being structured for multiple years, perhaps with some kind of draw-down feature to cover reinstatement requirements. Such vehicles may not have emerged yet not because capital providers are not willing, but rather because prices haven’t been adequate across longer-tail lines of business.
There are some areas of the reinsurance market where the participation of alternative capital is unlikely and unwarranted, however the report suggests that U.S. workers compensation as a market has both the availability of data and the scale likely to attract investor, making the entrance of investors to that market a realistic prospect at some point.
The report concludes that we will see rate declines at the January renewals, with even lines unaffected by loss perhaps suffering low double-digit rate declines. However do not expect a return to rate volatility seen in the 1990’s, as the increased sophistication of the market and ability of both traditional and alternative capital to take on risk means the pricing cycle has been flattened somewhat. We may be approaching a new normal of softer, but not quite soft, pricing across many reinsurance lines.
Peel Hunt are far from the first to forecast further rate declines at the 1/1 reinsurance renewals, but as the renewal period gets ever nearer and the first indications of pricing emerge from conversations in the market, the forecast for low double-digit declines looks set to be accurate at least across some catastrophe reinsurance lines of business.