Recent strong inflows of capital, from alternative and capital market sources, into the insurance-linked securities and collateralized reinsurance space have had an effect on pricing which even ILS fund managers are beginning to talk about. Typically it is the traditional reinsurance providers who bemoan the impact of capital inflows on the reinsurance premiums they can earn, but now the collateralized sector is seeing a trend for profitable opportunities in private transactions.
The recent January renewals were a little disappointing for some sources of collateralized reinsurance capacity. Strong investor inflows in the last few months of 2012 were not able to be put to work due to a lack of primary catastrophe bond issuance which reduced opportunities, a lack of large reinsurance program opportunities, competitive traditional reinsurance terms and competition among capital providers.
Add to this a fairly significant return of capital from maturing cat bonds and reinsurance transactions, as well as a lack of opportunities in secondary trading of ILS and cat bonds, and some capital providers have found themselves awash with cash at the start of 2013.
It’s no surprise to hear that some investors are increasingly looking to private transactions, be they reinsurance, ILS or structured, ILW or insurance swaps. This is where investors are increasingly telling us they can get the best investment terms and premium rates. A number of investment contacts we speak with on a regular basis are looking to build out their internal capabilities in structuring, underwriting and risk modeling to enable them to begin originating, structuring and transacting their own deal-flow directly from clients, and this could lead to growth in privately structured collateralized reinsurance.
This is having a number of effects on the market. Firstly it is increasing choice significantly for reinsurance and retrocession buyers, bringing a new-breed of deal-ready sources of capital from ILS fund managers, collateralized funds backed by reinsurance operations and sidecars. These capital sources are becoming much more sophisticated than they were even two or three years ago.
A few years back these alternative reinsurance capital sources were just that, sources of capital which offered capacity for a decent rate of return. Now they are becoming much more discerning about the deals they get involved in, the risks they underwrite, they want to perform their own modeling and diligence on every transaction and they can deal with a cedent directly, cutting out the need for middle-men, if so desired.
This is likely the future of the alternative reinsurance capital (or convergence) space. A flexible, innovative, self-sufficient when it needs to be but equally willing to support large programs and brokers needs, adaptive and reasonably priced source of reinsurance and risk transfer capacity.
In a recent update on the DCG Iris insurance-linked securities fund, operated by investment manager Dexion Capital, the investment manager of the Master Fund, Credit Suisse, said that it is has noticed the influx of capital into the reinsurance space causing pricing pressure on cat bonds and ILWs.
In the update Credit Suisse said that it is seeing that “investment ‘sweet spots’ are more and more in privately negotiated layers” where their large line sizes and strong collateral security position are highly valued. This is a similar message to the one we hear when talking to investors who are seeking to strengthen operations and broaden their access to deal-flow by becoming more able to deal direct, underwrite on their own terms and add value to cedents.
This trend towards more innovative, independent, capable sources of alternative reinsurance capital will likely have its own impact on the market. In years to come we could see collateralized sources of reinsurance, such as fund managers, leading on large lines of reinsurance business with other sources of capital, including perhaps traditional reinsurers, topping up lines as it would once have been the fund managers doing.
The trend for ILS fund managers and collateralized players to have more robust underwriting abilities, stronger risk modeling and more innovative structuring skills could also put pressure on traditional reinsurance brokers on some lines of business. Cedents may find a more innovative solutions comes from a more nimble outfit, and if that outfit can also put up the capital to underwrite the reinsurance business then there could be a cost saving to be made too. This could also lead to more of the boutique structuring specialists launching, who seek to act as specialist product managers, designing reinsurance and retro covers which they know both sides of the market, cedents and investors, want.
The upshot of all of this is that the market is in a position right now where the rate of innovation could begin to rise more rapidly, driven by sources of reinsurance capital who have different motives and a desire to do things differently. This is another of the factors that large investors find attractive in reinsurance right now. They see an opportunity to engage with the market at a time when there is an opportunity for it to evolve, led by sources of alternative and collateralized capacity. Even Lloyd’s players are discussing the need to embrace alternative capital sources or be left behind.
Of course none of this should be taken as suggesting that the traditional reinsurance model is dead, far from it in fact, we believe that traditional players are also destined to become more innovative and flexible, partly due to the alternative reinsurance space increasing the rate of innovation in the sector. It’s an interesting time to be in reinsurance and risk transfer, the lines are blurring between roles and responsibilities and this is making savings for cedents a reality and offering new opportunities for capital to access the space and increasing its attractiveness for investors.
Current market conditions are exacerbating this effect and making it more noticeable. As soon as the cat bond market bounces back to life with new issuance we expect deals to be oversubscribed and keenly priced, as they were last year. The trend towards private transactions is one which will grow but we don’t expect it to become the core strategy with which alternative capital is deployed in reinsurance. What it does is give investment managers and funds more control over their underwriting, capital deployment and diversification strategies, which can only be a good thing to help the sector grow and continue to offer investors new opportunities.
As we’ve said many times, the test will be in how much staying power the capital has to sit out softer reinsurance markets and withstand losses. Some alternative reinsurance capital is still fairly speculative but there is an increasing portion of the market which intends to stick with it for the long-term and has the desire to mold the business model into one which supports longer-term investment horizons in reinsurance and catastrophe risk.