One of the points of discussion at the recent Monte Carlo reinsurance Rendezvous event was just how much capital might we see flow into the insurance and reinsurance market as insurance-linked securities and other fully collateralized instruments or vehicles from alternative and third-party investor sources.
Global reinsurance broker Aon Benfield was one of the firms that have now moved past the discussion of when the reinsurance and capital markets will converge, progressing to discussion of the post-convergence reinsurance world where alternative capital becomes a normal and growing part of the capacity deployed globally in reinsurance markets.
In a press release and report published to coincide with Rendezvous Aon Benfield discusses the impact that the next $100 billion of alternative capital will have on the reinsurance market. Aon Benfield suggests that this ‘next $100 billion’ could enter the reinsurance market over the coming five years, which would see the total size of the ILS and alternative reinsurance capital market reaching $144 billion.
The next $100 billion of alternative capital is going to be transformative for reinsurance market dynamics and the overall insurance landscape, according to Aon Benfield. Both insurers and reinsurers will benefit from the transformative period in the markets history, that began with the first $44 billion of alternative capital that entered the reinsurance market over the last decade or so, as the next $100 billion finds its way into reinsurance capital and underwriting capacity.
Aon Benfield considers the reduction of reinsurers cost-of-capital as a key change in the reinsurance market. This is a factor we already see today, as traditional reinsurers come to terms with insurance-linked securities and collateralized competitors which have a considerably lower cost-of-capital, and this will continue as more capital comes into the space.
The reduction in cost-of-capital will improve the value proposition for reinsurance, cheaper capital will enable cheaper underwriting, reductions in rates, more flexibility and may also force reinsurers to embrace innovation and advance product development, all of which is positive for reinsurance buyers and also for those reinsurers that embrace change.
Aon Benfield believes that the post-convergence reinsurance landscape will continue to bring new, collateralized and unlevered products to market which can be more beneficial to insurers than traditional reinsurance products when it comes to peak peril risk transfer.
This is certainly key to the reinsurance market finding space for another $100 billion of capital. Either innovation will have to drive new opportunities for this capital to be deployed or there will have to be some shrinkage of capital at reinsurers, perhaps the equity squeeze we recently wrote about.
So, new products, greater innovation and more penetration of fully-collateralized, capital markets backed reinsurance and risk transfer products will bring benefits to reinsurance buyers, but for reinsurance sellers there is also a need for structural innovation, changes to business models, in terms of capital structures and the way they leverage external investors and partner with third-party capital.
Aon Benfield expects three broad categories of financial transactions between reinsurers and investors to continue to occur, and become more common, as reinsurers adapt to the capital inflows and find ways to incorporate the additional alternative capital within their capital structures.
These three classes of transaction that Aon Benfield forecasts as the mechanisms for taking future inflows of alternative capital into reinsurers are:
- Insurance-linked securities (ILS) and catastrophe bonds, enabling the cost of underwriting capital to be reduced for peak and tail risk transfer.
- Sidecars, which also lower reinsurers cost of underwriting capital but can be targeted at the entire risk spectrum and broader lines of business than securitizations.
- Establishing asset managers and capital markets units, allowing reinsurers to accept mandates from investors which will in turn assist in lowering their cost of underwriting capital.
Of course it is not purely going to be peak, tail-end property catastrophe risks that another $100 billion of alternative capital is going to be targeting within reinsurance.
Bryon Ehrhart, Chairman of Aon Benfield Analytics, commented; “The benefits of this new capital will begin to extend beyond property catastrophe and mortality risks that are common features of the current ILS market and extend into many other reinsurance lines where loss frequency and severity are more predictable.”
As alternative capital spreads its influence into new lines of business within reinsurance it will also create new demand, new products and new structures. In order to move into some areas of the market, innovative product development is going to be required, which will in turn filter back to the core catastrophe risks perhaps increasing the penetration of alternative capital even further.
Ehrhart continued; “The January 1 renewal market for our clients will benefit materially from an excess of traditional reinsurance capacity and new alternative capital flows over light demand growth for reinsurance capacity. Our clients should expect to benefit from a competitive market even if a moderate hurricane season should develop.”
So Aon Benfield suggest that if the 2013 Atlantic Hurricane Season develops into a moderately damaging one the January renewals should still prove competitive in terms of reinsurance pricing and terms. This is aligned with other commentators who believe that the longer the market remains large loss free, and alternative capital continues to show increasing interest in reinsurance as an asset class, the bigger the market-changing loss event will need to be.
Aon Benfield’s report shows a breakdown of the current $44 billion of alternative capital which is in the reinsurance marketplace right now. They see the split as $20 billion collateralized reinsurance, $2 billion collateralized industry loss warranties (ILW’s), $4 billion sidecars and $18 billion catastrophe bonds and other ILS bonds.
The graph (below) clearly shows the explosion in the collateralized reinsurance space over the last few years as it overtook cat bonds as the dominant form of alternative capital in reinsurance.
Based on this, Aon Benfield believe that the most significant form that the next $100 billion of alternative capital will take as it enters the reinsurance market will be through reinsurer established asset management vehicles. However, it is worth noting that dedicated ILS and alternative reinsurance capital managers and funds are well positioned to compete directly for capital inflows over the next five years.
The established ILS asset managers have already been turning down capital in the last two years and have the relationships in place to potentially put a spanner in the works of reinsurers asset management plans by competing strongly to attract capital. New investors to the space are going to be doing diligence across a wide spectrum of independent and reinsurer-owned asset managers in years to come and in some cases the independent and already established asset managers with a track record may be preferred.
This is actually going to be one of the interesting dynamics to watch in years to come, who wins the mandates and where the investors capital is trusted to. This dynamic could result in some consolidation among independent ILS asset managers but could also see reinsurers stripping back from large financial firms to more nimble asset focused operations.
Overall Aon Benfield predicts that the amount of alternative and third-party sourced capital in reinsurance is going to continue to grow over the next five years. For catastrophe bonds, it is expected that issuance will continue to outstrip maturities, despite levels of maturing bonds being high for the next few years, which will help that part of this alternative reinsurance capital market to continue to grow.
Whether we see another $100 billion flow in, less than that if the market cannot expand quickly enough to absorb it, or possibly even more if pension funds continue to find the asset class attractive, the outlook for the reinsurance market is one of transformation.
Reinsurers, brokers and supporting service companies, will have to adapt to new business models and capital providers to ensure the inflows can be accepted and profited from. Innovation, around product and service development and business models, will be essential to ensure that the new capital can be put to work and market opportunities for alternative capital are broadened. Finally all sides of this transforming market are going to have to maintain diligence, standards and remain focused on accurately pricing and underwriting risk at whatever their new cost-of-capital ends up at post-convergence.
You can access a copy of the full report from Aon Benfield, titled ‘Post Convergence: The Next USD100 Billion’, here.