The Lloyd’s of London insurance and reinsurance market remains “determined to harness” the alternative reinsurance capital trend, according to its latest annual report which shows that the market’s return on capital dropped to 14.7% from 16.2%.
Lloyd’s, as a specialty provider of insurance and reinsurance products across a vast range of business lines, is acutely exposed to the growing influence and expansive nature of third-party reinsurance capital from institutional investors, wielded by insurance-linked securities (ILS) investment managers.
It’s also exposed to increasing competition from new reinsurance business models, particularly those that seek to disintermediate the market, retain more of the profit from risk business, or that look to do things more efficiently and at lower cost.
The end result is pressure across much of Lloyd’s once core business lines, particularly property catastrophe of course, but also in specialty risks lines such as marine and energy and increasingly casualty lines pressure is also weighing on the market.
So it stands to reason that Lloyd’s would continue to target alternative capital and seek to attract it to do business in the market and once again the market’s annual report discusses the alternative, ILS and third-party reinsurance capital trend in some detail.
The report explains the problems that the Lloyd’s insurance and reinsurance market faces:
Competition within the insurance industry intensified with capital, including from alternative sources such as hedge funds and institutional investors, gravitating to insurance in the search for elusive returns. Greater consolidation is expected during 2015 with a rise in M&A activity across the industry.
Prices in most classes remained under pressure, challenging profitability in an environment of reduced investment income. While the past two years have seen relatively benign insured catastrophe experience, the long term trend is for an increasing frequency and severity of catastrophe claims and rising underwriting exposures.
In order to generate appropriate returns for shareholders, the consensus is that prices need to rise to reflect increased exposures and risks in the market and the pressures on investment income. However, excess capital and intense competition make broad based price increases unlikely.
That last paragraph is key. The “consensus” at Lloyd’s is that prices need to rise. But if other markets are still able to deploy capacity into re/insurance business at these low rates, and excess capital remains available to them as well (or on the sidelines) what chance is there that rates will get back to levels that really satisfy shareholders?
If, after the next major slew of losses the market cannot push rates as high as it wants, as there continues to be increasing amounts of new and alternative capital flowing into the market, might it suggest that companies needing these “higher returns for shareholders” perhaps have business models that are unsustainable anymore? Time will tell.
At the same time as it faces clear pressures Lloyd’s also wants to attract new sources of capital, including becoming more open to alternative and ILS players. Lloyd’s prides itself on its long history of working with third-party capital and innovation and this is a key component of the markets five-year strategy, which says:
Lloyd’s reputation for innovation will be demonstrably enhanced, in part through embracing ‘alternative’ capital and products.
John Parry, Director of Finance at Lloyd’s, discussed the market’s capital mix, saying that the market wants to attract a capital base that is the “right amount and the right quality in the right place.”
Parry said that Lloyd’s had worked through 2014 to encourage non-traditional sources of capital into the market to help it to diversify its capital base further.
“The growth of alternative products and capital is well established in the reinsurance industry and we are determined to harness this trend in the years to come,” Parry explained.
He went on to say that maintaining the attractiveness of Lloyd’s to a diverse range of capital providers is “fundamental” to the insurance and reinsurance market’s future success.
Chairman of Lloyd’s John Nelson highlighted “the challenge of excess capital, partly caused by low interest rates” which he acknowledged is causing a structural change as it comes into the market.
This excess capital is having the effect of “lowering premium rates and in part changing the way in which business is being structured, particularly in reinsurance” Nelson explained.
Chief Executive Inga Beale highlighted some successes that Lloyd’s is having attracting new capital to the marketplace, saying; “The market also welcomed three new special purpose syndicates. These are proving a popular way for existing and new capital providers, particularly from developing markets, to participate in Lloyd’s.”
However Beale also noted the issue of excess capital, adding; “In the wider industry, a persistent imbalance between capital and risk is triggering increased competition, making organic growth difficult.
“In this context it is unsurprising that there has been a spike in M&A activity; the same happened in the mid to late 1990s. We expect this trend to continue through 2015 and accept the gauntlet that this consolidation throws down – to protect and promote the diversity of the Lloyd’s market.”
Lloyd’s agrees with others who see the prospects for 2015 worsening, as future renewals continue to see declining prices and more capital enters the sector, both from alternative sources and into new joint ventures.
The report explains:
The impact of this has already surfaced in the January 2015 renewals which again saw large reductions in several core lines of business. This trend is likely to continue as 2015 progresses with the potential for alternative capital to increase and widen beyond property catastrophe reinsurance. The capital markets see insurance, particularly the incidence of natural catastrophes, as a diversifying asset class with relatively attractive returns. This will drive further downward pressure on rates, terms and conditions, and coverage.
And here’s where the trend begins to really impact on Lloyd’s, perhaps being the catalyst for the reduction in return on capital in the market.
Contraction was evident in some catastrophe classes, notably property treaty, as a result of growing competitive pressure. Fuelled by the influx of capacity from alternative capital providers, and a period of relatively benign loss activity, property catastrophe reinsurance continued to record the most noticeable downward movement in rates. Even in classes impacted by large losses, such as aviation, the ready supply of capacity only dampened the momentum for a sustained improvement as the market moved swiftly to access any possible opportunities.
The Lloyd’s insurance and reinsurance market faces the same pressures as the large, globally diverse reinsurance companies (the Swiss Re’s and Munich Re’s of this world), that as the market evolves it is resulting in lower returns, more competition and in some cases reducing access to business.
Lloyd’s is exposed to the growth of ILS and collateralized reinsurance managers and funds. Market participants we’ve spoken with suggest that some smaller Lloyd’s syndicates are now beginning to be pushed off reinsurance programme renewals, as ILS managers can put down larger lines and be more competitive on pricing.
Lloyd’s is also exposed to the emergence of joint-ventures, which allow insurers or reinsurers to retain more profit from underwriting business, access new sources of third-party capital and are effectively going to reduce risk going to global re/insurance markets.
Of course the retention, aggregates, multi-year covers and move by big cedents to reduce their panel of counterparties can also impact smaller Lloyd’s syndicates as well. So the market faces all of the pressures that everyone else faces, and one of the results of this is the decline in return on capital.
But, given the Lloyd’s of London market model, with a range of third-party and company capital providers welcomed, it is actually better placed to benefit from the alternative capital trend than many large competitors.
Lloyd’s does not have a balance-sheet, in the same way as a reinsurer. It can pull in the most efficient capital to help it to lower its cost base and enable it to operate at a reduced return on capital, without having a duty to shareholders to uphold.
Granted the companies in Lloyd’s do have this duty, as do syndicates to their capital providers, but Lloyd’s itself is actually positioned to lead the disruption occurring in the reinsurance market, rather than be a victim of it.
The message continues to be that Lloyd’s will look to embrace new sources of capital, alternatives and new products. For this to work though, some of the less efficient capital may be forced to exit the market, we would imagine, in order to make way for more efficient capital that wants a more direct access to risk.
Would Lloyd’s go that far, for example turn over much of its capital base, establish a raft of special purpose syndicates and embrace the large pension funds of the world?
Perhaps, but likely not at a quick pace, which could be to its detriment. If the re/insurance world is changing Lloyd’s needs to change with it too. If it doesn’t change fast enough it may mean the return on capital struggles for a few more years as the ’embracing’ begins to take shape.