The low-cost and abundance of reinsurance capital, both from traditional and alternative or third-party sources, is enabling some insurers to play the reinsurance arbitrage game, as they exploit price disparities with direct insurance, according to S&P.
This practice has been especially evident among commercial lines insurers, according to rating agency Standard & Poor’s, as they are increasingly seeking to take advantage of reinsurance arbitrage, to profit through the exploitation of price differences between the direct insurance they underwrite and the softness of reinsurance capacity.
It’s particularly interesting that this is pointed out by S&P, as this is a trend which has helped to encourage some alternative reinsurance capital providers, such as ILS fund managers, to access commercial insurance lines more directly.
With the reinsurance market so soft and competitive, third-party capital providers such as ILS funds have been applying their risk capital more directly to back commercial property insurance risks. This enables them to almost directly reinsure large quantities of primary risk, as effectively the primary risk is underwritten with their third-party reinsurance capital, extracting additional value thanks to the exact same pricing arbitrage.
Reinsurance price arbitrage has, of course, also been evident as the market softened between primary reinsurance and retrocession, with some evidence of both traditional and ILS players taking advantage of disparities between the two at times.
But primary insurance companies have now noticed this opportunity as well, perhaps another sign of the desire to increase efficiency and leverage any opportunities to reduce expenses as insurers face dwindling investment returns, some softening of their prices and increasing competition.
S&P explains that this reinsurance arbitrage has emerged despite the fact that “reinsurance pricing declines have not reached their trough” which suggests that there is further to go and the arbitrage opportunity may increase.
“We are seeing commercial-lines insurers strive to take greater advantage of reinsurance arbitrage (profiting by exploiting pricing differences between reinsurance and direct insurance),” S&P continues.
S&P notes that this time around, and unlike in the 1990’s, the reinsurance arbitrage opportunity being taken up by commercial lines insurance firms is more disciplined.
“The good news is that U.S. cedants have not changed their underwriting appetite and have not set their risk tolerances based on the availability of reinsurance,” S&P explained.
“Instead, reinsurance offers cedants the opportunity to increase their gross limits while maintaining the same net limits.”
And efficiency is key in all of this, as insurers face similar pressures to reinsurers, in terms of low investment returns, higher competition and softening pricing, so they are taking every opportunity to improve their combined ratios and lower expense ratios.
“Cedants are taking advantage of higher ceding commissions, which improves their expense ratios,” S&P said. “We also notice reinsurers offering treaties for businesses that are traditionally written on a facultative per-risk basis, which we view as a more efficient form of reinsurance.”
The efficiency of reinsurance, both in terms of the efficiency of the risk capital and the efficiency of the structure or contract form, are other areas that insurers can currently benefit from and gain a few points of profit.
“Some reinsurers are willing to consolidate or write on treaty paper the former facultative per-risk policies,” S&P said.
While at the same time; “To play some offense and take advantage of soft reinsurance pricing conditions, some traditional specialty writers have increased their gross limits.”
Hence strategic buying and restructuring of reinsurance programs seems to be ongoing. After the well-documented centralisation of buying came first, now perhaps a more thoughtful look at how to make the most of reinsurance capital and structures in all their forms is emerging, with this arbitrage part of that process.
And S&P stresses that despite the fact cedants approaches to reinsurance purchasing differ, “the common denominator is that reinsurance optimization does not translate into underwriting dilution.”
That’s one thing the rating agencies have warned on from the start of the softening of the reinsurance market, that ceding companies should not take advantage of the cheapest reinsurance capital to enable rapid growth, support poor underwriting standards or reflect reduced risk management.
So it’s encouraging to read from S&P that it does not believe this to be the case, at this time.
S&P is pleased with the discipline displayed by the U.S. property and casualty insurance market, the rating agency explains, despite the fact that benign catastrophe events and improving frequency loss-cost trends have helped to exacerbate the industries capital position, resulting in the build up excess organic insurer capital as well as reinsurance and third-party capital.
“Such a windfall could have set the stage for irrational pricing had it not been for the industry’s staunch focus on underwriting discipline and optimization of data analytics,” S&P explained.
But overall S&P feels that the U.S. P&C insurance sector has been “dealt a good hand” adding that it does not see insurers “rolling the dice and paying the price”, rather they are acting with foresight regarding the challenges they will face in the future.
Reserves is one challenging area that S&P highlights though, saying that it is “surprised that reserve releases are still robust” and goes on to explain that this is “a trend that is not sustainable.”
Despite that and the fact that P&C insurers are expected to continue to suffer from low investment returns and combined ratios are forecast at 98% to 100%, S&P remains stable on the U.S. P&C insurance sector for now.
Clearly capitalisation has a great deal to do with this outlook, with the organic capital of insurers high and increasingly supported by reinsurance and third-party or ILS capital.
Now insurers are able to profit slightly from the reinsurance arbitrage, thanks to the efficiency and lower cost of reinsurance and ILS capital. At the same time reinsurance buying strategies continue to evolve, with efficiency increasing and further savings or additional profits to be gleaned.
Of course the fact this arbitrage opportunity currently exists suggests that increasingly third-party reinsurance capital and insurance-linked investment fund managers will look to benefit from this themselves, by directly backing primary property insurance portfolios with their risk capital.
It also means that for large U.S. primary insurers, now might be a very good time to set up some kind of third-party capitalised captive reinsurer or sidecar-like vehicle, as the arbitrage can become even more profitable if you bring the third-party capital in-house.