To a greater extent than historically, insurance and reinsurance is more “interconnected with wider capital markets” than before, which alongside the inflow of institutional investor capital has helped to drive expected returns down, according to the UK’s Prudential Regulation Authority (PRA).
In a speech this morning to the audience of the General Insurance Research Organisation conference in Dublin, Ireland, David Rule, Executive Director of Insurance Supervision at the Bank of England’s PRA, discussed the need for risk to be managed in a soft insurance and reinsurance market.
As you’d expect, the topic of alternative or third-party reinsurance capital and the growth of insurance-linked securities (ILS) investment was raised, as it typically is during any discussion of market forces given the impact that a business model backed by efficient capital has had on the traditional industry.
To begin, Rule highlighted the fact that soft market’s need disciplined responses.
“The margin for error in the running of general insurance firms has reduced – firms have to underwrite profitably,” he explained. “On the positive side, this emphasises the importance of underwriting discipline.”
The current soft market makes insurance and reinsurance profits harder to achieve, he continued, going on to explain what the PRA feels has caused the soft market.
“It is surely in part just another manifestation of the wider low return environment,” Rule said, adding “The most obvious evidence is the inflow of capital to the market from institutional investors.”
Pleasing that he termed this as the “most obvious evidence” as it’s clearly not the only cause of a soft market in a low return environment. Looking at traditional reinsurers use of diversification discounting is another sign of capital being deployed more cheaply into re/insurance in a low yield world.
It also doesn’t recognise the lower cost-of-capital that some ILS investors and ILS fund managers feel they benefit from, enabling them to underwrite at levels that have pushed traditional markets to break free from the underwriting profit margins they once enjoyed.
Rule then explained it perhaps as well as anyone; “Perhaps to a greater extent than historically, insurance is interconnected with wider capital markets and market forces have driven expected returns more into line with other investment opportunities.”
This comes down to the fungibility and mobility of capital, as well as investors expected returns, a key reason for the decline of catastrophe bond prices. Add to that the fact re/insurance is a very attractive asset class, both directly through investing in risk and ILS as well as through equity stakes in companies, and it’s easy to see how wider capital market forces play a factor in the current soft insurance and reinsurance marketplace.
Capital and the markets it flows through are more connected than ever before. By connecting these markets we add efficiency, something that began with the first catastrophe bonds and continues today with the growth of ILS funds, collateralised reinsurance, the move up the value-chain to get nearer to the source of risk and now the rise of Insurtech.
Insurance has always been about risk capital and perhaps where we are heading is a risk capital market, rather than insurance and reinsurance. This reflects the disruption to the value-chain, erosion of intermediation and focuses the business model on transferring risk to capital as quickly and efficiently as possible, something we see as accelerating right now.
Rule of the PRA went on to stress that insurers need to ensure their pricing covers their view of risk. However, as the view of risk improves, technology and insurtech enhances data granularity and ability to analyse it, while also removing intermediation, the cost and as a result pricing of risk will come down.
For the PRA, its main focus is in ensuring that re/insurers remain disciplined. However, remaining disciplined in a world where capital is moving ever more rapidly and reducing in cost, while the transport of risks to capital is accelerating and becoming increasingly efficient, will no doubt maintain pressure on traditional business models which fail to adapt and evolve.
Rule said that market turning events could herald some respite for re/insurers, however he said that hopes of capital reducing after a major event may be optimistic.
“Some in the industry talk of the need to have naïve capital and capacity cleared out of the market, restricting supply and supporting premium above the technical price level, there is a sense that, this time, things may be different.
“Many believe that further capital is ‘waiting in the wings’ to invest in the sector in the event that prices rise,” he explained.
Rule stressed the need for holding “adequate and appropriate” capital against the risks that insurers and reinsurers face, given the softness and uncertainty that the market faces.
Appropriate is an interesting word here, given it is entirely possible that re/insurers increasingly have to look to third-party capital backed balance sheets in order to increase the efficiency of their own capital. Or that they have to morph into originators, analysts and pricers of risk, while capital is supplied by others.
“The key challenge for insurers is how they preserve or even grow their activities while avoiding the ‘Winner’s Curse’ of under-pricing in order to get the business,” Rule said.
That is only going to get more challenging as the market continues to structurally evolve, pressure to increase efficiency rises and competition grows.
The PRA will have its hands full, both monitoring the traditional market and keeping abreast of the new business models that emerge. The regulator is clearly cognizant of the changes affecting the re/insurance market, now it needs to get its crystal ball out to ensure it can see what’s coming next.
Insurance and capital markets are connected and the interlinking of the two will only become deeper, as efficient capital seeks access to risk related returns and insurtech binds the two together ever more closely.