Equilibrium between capital markets and reinsurance will be reached

While much of the news and analysis on the global reinsurance market is focused on an increasingly influential third-party capital and insurance-linked securities (ILS) market and the impact it is having on traditional reinsurance rates and pricing, Charles Philipps, Chief Executive of Amlin expects the capital market and reinsurance to find equilibrium.

A lot of coverage on the recent pricing trends has tended towards a discussion on the current impact to traditional reinsurers, ours included, there hasn’t been a lot of focus on how the trend towards leveraging third-party capital within reinsurance underwriting will play out further down the line.

As we wrote last week, Amlin is well positioned to capitalise on this trend with its investment in the established ILS and reinsurance-linked investment manager Leadenhall Capital Partners. Amlin is increasingly finding synergies in its reinsurance business and how it interacts with Leadenhall and it’s clear from comments made by the senior management team at Amlin on a recent analysts call that it is pushing to position itself as a leader in the ILS and reinsurance capital markets once this equilibrium is found.

So in this piece we’re going to cover off the comments made by Amlin’s senior team on the analysts call regarding the firms first-half 2013 earnings. The comments give some insight into how Amlin and Leadenhall Capital Partners are working together and how Amlin is positioning itself for a time when third-party capital could make up as much as 30% or more of the global catastrophe reinsurance market.

We start with comments made by Simon Beale, Group Chief Underwriting Officer at Amlin, who discussed recent reinsurance market trading conditions. Beale said that an absence of losses in the market combined with the influx of capital markets capacity pushed Amlin’s June catastrophe renewals down by an average of -14.9%. In July that decline moderated somewhat, averaging out at -8.3%.

Further declines are anticipated through the rest of this year and into the 2014 renewals. Amlin expects to deploy capacity as normal in January, but if the rate declines persist through to the mid-year 2014 renewals it could begin to look more closely at how its capacity is being deployed and for what return.

At the moment Beale said that alternative reinsurance capital has been largely focused on U.S. and Florida catastrophe reinsurance, but Amlin is now noticing it beginning to look for new opportunities in other geographies and perils. Beale specifically noted that some ILS funds and collateralized reinsurers are looking to new geographic markets and also beginning to deploy capacity into reinsurance business with lower attachment points as they seek to broaden their reach.

Beale added that Amlin see this as a long-term trend that we’ll see in the reinsurance industry, for third-party capital to gradually seek new opportunities, but noted that there are some factors which hold this back. He cited the reluctance for alternative reinsurance capital to move into unmodelled perils and territories, a limited capability to offer second event cover and a continued uncertainty among some clients over how sticky this third-party capital will be as issues that slow the progress of the sector.

Amlin itself feels well positioned for the changing marketplace, Beale said, with two factors on its side, providing a competitive advantage to help it cope with the ‘new normal’ of third-party capital in reinsurance. Firstly, its strong existing franchise and broad expertise positioning it as a preferred market for reinsurance business.

Secondly, Amlin’s relationship with, and investment in, specialist insurance-linked securities investment manager Leadenhall Capital Partners, offers it an edge some competitors do not have and allows Amlin to create combination traditional and convergent reinsurance solutions for clients. This gives Amlin significant strategic options which will allow it to more formally improve its offering with the support of Leadenhall Capital, according to Beale.

Charles Philipps, CEO of Amlin, then discussed the firms strategic approach through which it aims to ensure it can participate in and maximise opportunities in ILS and managing third-party reinsurance capital. Philipps began by saying that Amlin feels it is well positioned to weather the impact of third-party capital which flows into the reinsurance market through insurance-linked securities (ILS), collateralized reinsurers, sidecars and other vehicles.

Philipps said that it is Amlin’s diversity of distribution and strength of reinsurance franchise that provide it with an edge in the traditional reinsurance market. Additionally the relationship with Leadenhall Capital positions Amlin uniquely in London, with a leading reinsurance and ILS business.

In ILS and the capital markets, Philipps said that Amlin feels it has an early mover advantage with Leadenhall Capital’s long-standing and growing position in the market. Citing Guy Carpenter Philipps said that the capital markets may account for 30% of catastrophe reinsurance limit over the next few years. However, Philipps said that most of this capacity does not compete with Amlin as it operates at different levels within the reinsurance market. Competition is increasing, Philipps acknowledged, with some capital market ILS players beginning to move down the risk curve, thus increasing competition at levels where Amlin does participate.

Philipps said that at Amlin they believe that the capital markets are here to stay in reinsurance. But he believes that the traditional and alternative reinsurance capital will find a way to play nicely with each other, in a complementary and symbiotic fashion.

Philipps commented; “An equilibrium will be reached, whereby the capital markets will focus on providing a sound, higher end risk transfer mechanism where collateralized cover is expedient for clients, as well as a more remote retrocessional reinsurance market.”

This would leave the traditional reinsurance market to dominate the working layers of the reinsurance market, while the capital markets will be available to protect Amlin’s catastrophe risk, as it already has been, Philipps added.

This is refreshing to hear after the recent fad for talking up either alternative or traditional reinsurance capital. In essence Philipps comment harks back to the reasons that ILS, catastrophe bonds and the capital markets participation in reinsurance was first considered appropriate. That there are layers within the reinsurance market, particularly on peak and remote perils where the reinsurance market alone cannot bear the true extent of the risks. In those cases the capital markets, as the largest source of capital available, were seen as likely bearers of that risk if adequately compensated. Hence the development of catastrophe bonds as a way to transfer risk to the capital markets via securitization.

Philipps is certainly correct in his assumption that traditional and third-party capital will find its place where it is best deployed and risks meet the return requirements. In this way the two forms of capital can be thought of as complementary and an equilibrium will certainly be reached once the penetration of the capital markets into reinsurance levels off.

However the ambition of some third-party capital providers has changed since those early days when cat bonds were first created and opportunities to profit were seen after heavy catastrophe loss years. The ILS markets and third-party capital do have an ambition to play much more deeply across the reinsurance, and perhaps even insurance, space now, so while we will find an equilibrium in catastrophe reinsurance it will be interesting to see how the trend continues to manifest itself in other areas of the marketplace.

Of course, the capital markets may find its appetite satisfied with a larger percentage of the global catastrophe reinsurance market and a good slice of the retrocessional reinsurance market. Retro in particular is a market with room for considerable growth and third-party capital is suited to this area. It’s going to be interesting to watch how this plays out. We feel an equilibrium is likely, as Philipps suggests, but we may see continued efforts to move third-party capital into other areas of the re/insurance market which right now are difficult to predict.

Philipps explained that Amlin believes there are three reasons that an equilibrium will be reached. Firstly, the inflow of third-party capital will slow as bond yields recover over time. Secondly, capital market investors recognise that reinsurance rates, and hence returns are weakening, and that they will therefore re-appraise their risk appetites. Thirdly, some of the capacity that has entered the market, particularly lower down the risk curve, will Philipps suggests be hit by material losses, some of which may be unexpected and this will result in investors again re-appraising their risk appetite.

Philipps again makes a lot of sense with these three points, however he doesn’t account for the scenario of what may happen were a major catastrophe loss event to occur, which could have the effect of raising rates again and encouraging more capital into the market.

Philipps said that Amlin has strategically positioned itself so that it has a good understanding of ILS, so that it can raise capital via ILS and that it is in a good position to strengthen its reinsurance franchise via ILS synergies as well.

Philipps cited three examples of Amlin’s use of third-party capital and ILS. Firstly Syndicate 6106 with which Amlin can raise capital and earn fees, warehousing risk which Amlin can grow into if it chooses. Secondly he mentioned Tramline Re, Amlin’s recent catastrophe bond program, which can provide it with retrocessional protection via the ILS markets.

Finally Philipps referred back to Leadenhall Capital again, which gives Amlin the ability to manage third-party capital and earn fees using its reinsurance expertise and with no risk to its own balance sheet. With Leadenhall Amlin feels that it is ahead of its competitors and is beginning to find increasing synergies between the ILS manager and its traditional reinsurance operations.

Interestingly Philipps noted that Leadenhall has a pipeline of prospects for further fundraising, above and beyond the $1.4 billion of assets under management the ILS specialist is currently managing. Philipps then went on to explain some of these synergies in more detail.

Amlin can provide Leadenhall with better access to deals to deploy its capital than some of its competitors may have, Philipps explained. Amlin also has the ability to provide Leadenhall with access to private transactions that it may not have had access to without this relationship and which its competitors may not be able to access. Philipps also noted that Amlin can provide infill capacity, for reinstatement cover (or second loss protection) for Leadenhall clients, something that collateralized ILS cover on its own cannot provide and a key selling point at renewal.

Philipps said that he expects Leadenhall Capital will continue to grow and become one of only a few meaningful players in the ILS space. For Amlin this means a symbiotic relationship which will bring in a growing contribution of its earnings without any balance sheet risk. He said that the foresight of setting up Leadenhall early on will continue to reap Amlin benefits.

Group CUO Simon Beale then gave a little more insight on how Amlin and Leadenhall Capital work together. He said the two firms have worked together on a number of clients, where there is a tendency for the client to want collateralized cover for its tail risks. The benefit of this is that Amlin can go to clients with a full-spectrum product offering including collateralized protection for peak tail risks. Other potential opportunities could become available around retro and nationwide programs, said Beale, or on programs where Amlin can step in to assist Leadenhall with traditional reinsurance features or for assistance in helping its clients release capital after a catastrophe event.

Beale said that almost 50% of Leadenhall’s private deal business has come via Amlin and the firm has fee arrangements in place for giving Leadenhall access to such business. Philipps said that there is a huge opportunity to make the symbiotic relationship between the two firms work even harder. On how big this opportunity could be, Philipps said that would depend on funds raised and access to business, but he acknowledged that it is a major opportunity for the firm.

With the current growing trend towards managing third-party capital within insurance and reinsurance businesses Amlin clearly feels that Leadenhall Capital Partners is increasingly important to the firm from a strategic point of view, adding a new angle and benefits to its reinsurance franchise. For Amlin itself, this may mean a period of change is coming as it adapts to this new world of third-party capital within its underwriting.