Emerging model of ‘fast capital’ threatens traditional reinsurers: Willis Re

Some traditional reinsurers now see the emerging reinsurance business model of ‘fast capital’, or the flow of capital into the reinsurance market from third-party investor sources, as a direct threat to their existing portfolios, according to the latest renewals report from reinsurance broker Willis Re. The report notes a jump in the amount of capital which has flowed into the reinsurance space this year, currently adding up to around $35 billion of capital from these sources.

The report opening letter from Peter Hearn, Chairman of Willis Re and John Cavanagh, CEO of Willis Re, echoes many of the our recent articles on this topic (see the bottom of this article for links to some of these). We’ve discussed in detail the growing trend for third-party investor capital to enter the reinsurance space in a variety of forms, from investors participating in catastrophe bonds, to dedicated ILS investment funds, listed reinsurance vehicles offering investors ways to participate in reinsurance underwriting, sidecars and new reinsurer operated third-party capital management facilities.

Willis Re has clearly been watching this trend closely and agrees that we are approaching a tipping point where traditional reinsurance firms are beginning to see it as a threat to their business models, or in some cases an opportunity as well.

The inflows of capital from third-party investors have reached $35 billion in 2013, according to Willis Re. That’s a healthy 30% increase from a year ago when it stood at $27 billion, according to comments made by James Vickers, Chairman of Willis Re International, in the FT today.

Capital markets have been expanding the scope of their activities in the alternative investment space, according to the opening letter of the report, and investors are seen to have an increased interest in and be placing more emphasis on the universe of insurance event risk. There is clear evidence of an acceleration of fresh capital coming into the reinsurance space seeking new opportunities, according to the report.

The opening letter states; “Faced with this wave of new capital, traditional reinsurers have begun to recognize the scale of the challenge to their current portfolios that the new capital represents. While some reinsurers are considering how to respond, others are developing third-party capital management propositions to offer their own skills and platforms as fund managers.”

Willis Re believes that the new capital is not just changing the game for traditional reinsurers, but is also likely to have a significant impact on the reinsurance markets post-event response after a major loss event. This is the great untested aspect of the new third-party capital interest in the reinsurance market, however it is worth noting that capital interest just keeps on increasing even with the major losses suffered in recent years.

Interestingly, Willis Re note that in the past traditional capital has always come into the reinsurance market in the form of new companies set up to leverage rates and opportunities. Willis Re says that this model is being overtaken by one which sees ‘fast capital’ flowing into the market through less permanent structures and says that in an industry where primary insurers value sustainability this new model may bring challenges.

This interesting viewpoint from Willis Re is one which would be challenged by many of the ILS investment funds, third-party capital vehicles and listed reinsurance funds, who all see themselves as more permanent fixtures in the reinsurance market. In our view, it is not the reliability of the structures that is questionable, rather the underlying sources of capital which would likely see some flux post major loss events, as is only natural. The question is how much capital will be sticky and then also how much new capital would flow in to replace any that exited the sector. However this is still to be tested and it may take a major U.S. hurricane season, or other equivalently large loss event, to really see how this plays out.

Willis Re says that traditional reinsurers are beginning to express concerns about access to risk to feed their own growth aspirations. It’s not just the inflows of new capital into the reinsurance space which are causing this concern, it is also new distribution models among primary insurers, higher retentions, concentration of premiums into larger players hands and changing capital management strategies causing this concern and a change in market sentiment according to the report.

Vickers is quoted by the FT as commenting that with investors looking for uncorrelated yields and the low-interest rate environment persisting, third-party capital sources are looking for new alternatives, of which reinsurance is clearly one. He said that these investors only need to put in small allocations, around half a percent, and it can be a huge amount of capital flowing into the space. Vickers said that “Capital markets are coming in and taking traditional business away.” The FT article also quotes Vickers as mentioning the concern about what would happen when yields begin to look more attractive elsewhere?

Willis Re says in the report that rate movements at the 1st April renewals have not fully reflected the markets changing sentiment. However, some early signs of how the market sentiment and the impact of continued inflows of third-party capital may affect renewals are beginning to be seen. Willis Re cites the significant reduction in pricing seen in the latest Everglades Re Ltd. (Series 2013-1) catastrophe bond as well as insurer Allstate’s intention to grow its use of the capital markets and cat bonds, and reduce its traditional reinsurance placement, as signs of changes becoming evident which are driving more aggressive pricing.

Other areas that Willis Re has noticed the influence of third-party capital rising include the U.S. which has seen managed fund vehicles providing new capital to support the traditional markets at renewals. The capital markets are now providing more aggressive competition to traditional reinsurers in both regional and nationwide U.S. accounts.

Non-marine retrocession markets continue to see the influence of the capital markets, as funds continue to eat into the pie and sidecars have reallocated capital from oversubscribed 1st January renewals. Willis Re has noticed a high takeup of pillared retro products such as those offered by CATCo and PURPle. However Willis Re have noticed a reduction in industry loss warranty (ILW) activity, which it puts down to an increase in indemnity or ultimate net loss coverage through catastrophe bonds and insurance-linked securities (ILS).

On the capital markets specifically, the report says that the combination of new entrants to the market and additional new capital inflows are combining to both increase capacity and reduce spreads. Cat bond issuance has surged at the end of Q1 and that is expected to continue in Q2, according to Willis Re. Minimum coupons, or rates, have dropped for both life and non-life lines of business and indemnity trigger market share has continued to rise.

Despite the absence of a hard market, Willis Re says that sidecar and third-party capital initiatives continue to grow. Willis Re has noticed that some investors are favoring bonds, over collateralized reinsurance, while others are indifferent to the form the investment in risk comes in.

Against this background, Willis Re considers the outlook for many reinsurers to be challenging and said that profit margins may come under pressure in 2013.

As we’ve said before, the influx of third-party capital into the reinsurance sector is going to cause some changes to how business has historically been conducted in the space. There is a  need for insurers and reinsurers to adapt and innovate to keep up with the pace of change and ensure they are well positioned to embrace it as an opportunity rather than as a threat. If any reinsurers are going to suffer from this it will be the ones who fail to adapt or who move too slowly. The sector is in the midst of change and we may have to wait until this new era of third-party capital gets fully tested to be able to see how the future reinsurance landscape looks further ahead.

You can download the full report from the Willis Re website here.

Here are some other recent articles on this ‘new normal’ that may be of interest if you missed them (oldest first):

– Consolidation and pricing pressure possible as reinsurance convergence continues

– Capital flow in the reinsurance market has changed: PartnerRe CFO

– Insurance-linked securities (ILS) set to grow its share of reinsurance capacity

– Pension fund capital inflows could dampen returns over time: KBW

– Innovative and client focused approach required to drive growth in ILS

– As ILS investors compete with traditional reinsurers will they stay the course?

– Fast capital? Welcome to the ‘new normal’

– Lloyd’s: Third-party ILS capital is both a threat and opportunity