For reinsurers growth via alternative capital may be most attractive

In future some well-capitalised reinsurance firms may find it more attractive to grow their business through increasing intakes of capital from third-party ILS investors rather than by growing their equity investor base, says a report from Credit Suisse analysts.

Credit Suisse equity research analysts Michael Zaremski and Crystal Lu raise this interesting prospect in a report on capital management at insurers and reinsurers in 2014. With some firms looking as well-capitalised as they have ever been, it seems inevitable that some returns of equity capital will happen this year.

The analysts say that as reinsurance fundamentals deteriorate further with no sign of this abating and primary property casualty insurers pricing conditions are also forecast to moderate and perhaps turn negative, they expect increased levels of capital management in the form of dividends and share buybacks this year.

As a result of this expectation the analysts take a look at who may be looking seriously at how to return capital to shareholders or even to reduce their number of shareholders, as equity capital begins to look like a more expensive alternative on the reinsurance capital spectrum.

The analysts highlight the possibility that for reinsurers seeking to grow, either now or perhaps after the next major round of catastrophe losses when opportunities look more attractive, they may seek to do so through growing the ILS and third-party capital side of their business.

Think about it this way. Reinsurers are set to return equity capital in the current market environment, while at the same time many are setting up new units to manage third-party capital from institutional and capital market investors. When the next growth opportunity emerges, which form of capital is going to be the most attractive to pursue?

There is a good chance that reinsurers will place less reliance on equity capital, especially opportunistic equity capital, in future with the lower cost-of-capital associated with long-term ILS and alternative reinsurance investors possibly a much more attractive option.

The analysts use RenaissanceRe as their example in the report. RenRe is one of the reinsurers with a high level of excess capital, around 22% of shareholders equity according to Credit Suisse, but its margins are likely to remain under pressure in the analysts view.

The management at RenRe may decide that the third-party ILS investors that the firm has been working with for many years in its ILS ventures are ‘here to stay’ and provide a viable source of long-term capital. At the same time the management at RenRe may decided it wants to hold less opportunistic equity, or it may have returned a good amount by that time.

So in the event of a major catastrophe loss event which has the potential to move the market and rates, RenRe would want to be able to bulk up and take advantage of this opportunity. But at this stage it may be more attracted to growth with the help of its ILS platform and third-party investors instead of taking on new equity capital.

We’ve written about this possibility before, that equity capital may be squeezed out by alternative reinsurance capital, and that the lower-cost, more efficient money coming from the capital markets may prove to be a much more attractive way to expand and contract a business as opportunities allow.

The Credit Suisse analysts present this as one possible outcome of the current situation, where reinsurers may give back equity while at the same time developing their ILS platforms to be able to take on more money from third-parties.

There is a real chance that once the reinsurance market dynamic has settled a little, perhaps after a rate moving loss event, that we could see a small to mid-sized reinsurer transition towards becoming a majority, or even pure, ILS player. At the same time, who’s to say that a large ILS player won’t see the attraction of equity investors and a rating, encouraging it to transition the other way into a reinsurer?