The continuing influx of so-called convergence capital into the reinsurance sector, non-traditional capital from third-party, alternative, capital market sources, has had a very real impact on the reinsurance markets capital structure resulting in significant pricing pressure at the recent June 1 renewals, according to insight from reinsurance broker Guy Carpenter.
The reinsurance sector has seen “dynamic capital growth” in 2012 and 2013, according to the broker, helped by an influx of capital from these convergence sources. This surge in capital has now changed the nature of the reinsurance sectors capital sector, thanks to investors increasing comfort with deploying capital into reinsurance vehicles and structures.
This convergence of third-party and capital market capital into the wider reinsurance market has now had a significant effect on reinsurance pricing at the just completed renewals, according to Guy Carpenter. Peak U.S. property catastrophe lines of business are the most impacted, as surplus capacity and lower target returns (a result of increasing investor comfort) putting downward pressure on reinsurance pricing at June 1 and likely through the remainder of 2013.
“The reinsurance sector has exited the fairly consistent post-Katrina Florida property catastrophe pricing range,” commented David Flandro, Guy Carpenter’s Global Head of Business Intelligence. “This has been driven by a very real change to the sector’s capital structure and this change is continuing unabated. New sources of capacity are emerging with implications for pricing, availability and structure. Guy Carpenter is well placed to enable clients to capitalize.”
The impact of convergence capital on traditional reinsurance
The renewal update from Guy Carpenter notes that for the first time ever there have been instances where an insurance-linked securities (ILS) reinsurance solution has been more cost-effective than its traditional reinsurance equivalents. While the traditional reinsurance solutions have certain capital constraints on peak risks such as Florida wind, third-party capital is not constrained in the same way allowing it to charge less for some peak risks than traditional reinsurers.
“After years of evaluating the catastrophe bond market as a viable risk asset class, investors are now comfortable breaking away, or “decoupling,” from price levels set by the traditional market,” said Global Head of Property Specialty at Guy Carpenter, Lara Mowery. “The impact has been dramatic this year, with robust catastrophe bond, sidecar and collateralized reinsurance activity triggering downward pressure on rates in the traditional market in order to remain competitive.”
Guy Carpenter estimates that around $10 billion of new capital has entered the convergence reinsurance space in the form of catastrophe bonds, sidecars and collateralized reinsurance vehicles over the last 18 months, as investor interest in catastrophe risk and reinsurance as an asset class has risen.
The broker puts the size of this alternative and third-party capital backed reinsurance sector at $45 billion, consisting of capital deployed into instruments and vehicles such as catastrophe bonds, collateralized reinsurance, industry loss warranty (ILW) products and retrocessional reinsurance.
Impact of convergence capital on the Florida reinsurance renewals
As the reinsurance market moved towards the Florida renewals this year it became apparent that pricing was going to be significantly impacted by third-party capital. Recent catastrophe bond transactions issued during the first few months of 2013 showed a consistent decline in pricing, with some transactions achieving prices as much as 40% lower than an equivalent deal a year earlier. As well as the influx of third-party capital leading to reinsurance market surplus, the fact that Florida has been hurricane-loss free for seven consecutive years had also had a bearing on pricing according to Guy Carpenter.
“This year, market expectations going into June renewals were such that pricing would moderate in line with January 1 trends,” said George Carse, Head of the Tampa, Florida Office at Guy Carpenter. “During pre-renewal discussions held in February by Guy Carpenter, reinsurers and non-traditional capital providers suggested a later renewal cycle would be more beneficial to our clients. This held true as flexibility in pricing and structure options from both traditional and alternative reinsurance providers, coupled with a divergence of pricing between Florida-specific catastrophe bond transactions and the traditional reinsurance market, resulted in more substantial price decreases on average than originally anticipated.”
Interestingly though, the cat bond market may actually have seen even more issuance in advance of the renewals if the impact on traditional reinsurance pricing hadn’t been so dramatic. Mr. Carse added; “Although catastrophe bond pricing had a major impact on the renewal process and several Florida-only bonds were quoted, very few of these transactions went to market, as more traditional products became increasingly competitive.”
That is extremely telling, the fact that some cedents began the year looking to sponsor ILS or catastrophe bond cover as it was assumed to offer the best value, but by renewals time the impact that ILS capital had on traditional reinsurance pricing meant that they could move back to more traditional covers. That would suggest to us that collateralized reinsurance underwriters may have made a meaningful impact at the June 1 renewals, as their more traditionally structured products, but fully-collateralized and third-party backed nature, may have been the most attractive option for many sponsors who have not yet utilised cat bonds or ILS before.
Guy Carpenter notes that many cedents have taken advantage of the extremely attractive rates to expand their reinsurance cover either at the top end or aggregate protections which allows many to enter the hurricane season with much improved and strengthened protection. This may be the first year for many cedents, particularly in Florida, where they have been able to afford to expand coverage in such a way.
This June 1 2013 reinsurance renewal season has witnessed market dynamics that have never been seen before, and may never be seen again, in quite the same way. As the market adapts to the ‘new normal’, of significant influence and input from third-party capital and convergence reinsurance sources, the traditional reinsurance players will also adapt to be able to cope with this new source of competition. By the time the next major renewal season begins, at the end of the year, we could find that while third-party capital has grown even further, traditional reinsurers will be more ready to compete and reinsurance rates likely more stable.
Of course the usual caveats of major catastrophe events occurring applies and we still don’t know quite how either market will react when they face major losses. There is an increasing expectation that after a major catastrophe event third-party capital will be there in numbers to take advantage of improved rates and underwriting opportunities. There is a chance that, rather than see convergence capital leave the market as some expect, third-party capital could flood in after a major loss event taking even more market share from traditional players. Of course it is impossible to know how this scenario will play out and the global economic environment at the time will also play an influencing role in where and how capital flows in reinsurance move at that time.
One thing is certain, third-party reinsurance capital is going to continue to influence the reinsurance renewals over the years to come, but its influence may not be so marked as we have seen in recent weeks ever again. This is now the ‘new normal’ and third-party reinsurance capital is unlikely to ever go away. In fact it has been in the market for years anyway, just in different forms and largely wrapped in equity. The ILS market has helped third-party capital to realise the returns inherent in catastrophe and reinsurance risk, that has helped to increase the sector and its opportunities profile, and now it has a taste of those returns we can’t see it going away anytime soon.