Swiss Re Insurance-Linked Fund Management

Original Risk: A Society for Change Agents

Re/insurance & ILS investors to focus on value creation in 2015


Investors in the insurance and reinsurance sector are set to focus on picking stocks, or accessing opportunities, which demonstrate value creation in 2015, as the market stands on the cusp of real softness and alternative capital continues to grow its share.

Analysts at Macquarie Research believe that share buying investors will return to traditional stock picking methods when they target the insurance and reinsurance space in 2015, with a focus on value creation by growing book value, strong return on equity (ROE’s) and stable returns.

The pressure on reinsurance continues, the analysts note, with no sign of letting up. There are no major losses to turn the market, no sign of third-party or alternative capital investors losing their appetite for insurance and reinsurance linked investments, no reserve crisis brewing and no other financial factors that could see re/insurers hiking rates, meaning that gauging stocks on how they create, accumulate and hold onto value will be a widely held strategy.

Of course in the wake of the entry of alternative reinsurance capital and the ongoing growth of insurance-linked securities (ILS), it isn’t easy to see where that value is going to come from. ROE’s are clearly under threat from the reduction in pricing and softening of the market, at the same time the reserve releases which have buoyed reinsurer returns may not last forever.

So reinsurers face a reduction in returns (as pricing declines) and reduced opportunities (as ILS and alternative capital take a larger share), so where is the value creation going to come from?

Mergers and acquisitions is one avenue that is clearly being explored right now, with the largest of the deals so far revealed the XL Group and Catlin combination. As we’ve written, these M&A efforts will result in larger entities, with a potential for cost savings to be made. But getting to those savings and increasing efficiency may take time and also cost money. Will they be able to put the benefits of the deal into action quickly enough to avoid the worst impacts of a soft market? Time will tell.

Expansion is another way to create value for reinsurers. Expanding into new lines of business or new regions or the world can both create definite book value for shareholders. However, if the expansion is stimulated by the soft market, as a knee jerk response to shift premiums to somewhere not quite so soft, this may not be the best long-term strategy.

Expansion built on the back of expertise is the best way for a reinsurer to build value for its shareholders in this way, by hiring new teams, exploiting partnerships, or leveraging underutilised expertise it already had. Here real value can be created by building a new book of business focused on a new line of business, adding something tangible for the investors to benefit from.

Another way to create value is to develop new products. The largest global reinsurers, the Munich Re’s and Swiss Re’s of this world, have been ploughing investment into their large, corporate risks units, where they effectively offer insurance capacity for huge risks affecting the largest companies in the world.

Here the expertise built up over years of reinsurance business can be put to good use to bring structuring techniques, risk modelling and analysis, capital market elements, weather risk management, parametric triggers and other skill sets to their largest clients.

By creating complex, cross-line of business, risk management and transfer products for large clients these reinsurers have built some new business that it is hard for smaller players to compete with. A great example is Munich Re’s synergies with its weather risk management business, which it has been leveraging more strongly in the soft market environment.

Addressing large corporate catastrophe exposures is an area that reinsurers are expected to focus on to create value. These corporations, with massive global supply chains, carry huge exposures to weather, climate and natural catastrophe risks which are not being addressed at the moment.

Creating products which can be sold to these corporations to provide them with contingent risk financing on the occurrence of large weather, climate or catastrophe events, softening the impact to their businesses and supply chains, could be a real business opportunity which would create value.

Of course these efforts may be stymied by the ILS specialists and third-party reinsurance capital, which is also expected to go after these opportunities with capital markets based products that may in some cases prove as or more efficient than a re/insurance contract.

Primary insurance is, of course, another area where reinsurers are increasingly seeking to create value. All of the big reinsurers have operations targeting primary lines of business and this is expected to increase as firms seek to become capable of underwriting across the full re/insurance cycle.

Macquarie’s analysts cite their preferred investment targets in re/insurance as the largest of personal and commercial lines players, such as the AIG’s and CNA’s, the cheaper of the reinsurer stocks such as XL, or those that have demonstrated value creation like Allied World, or those with high ROE’s like Validus.

Overall, the number of insurance and reinsurance stocks recommended by Macquarie is shrinking, as it finds it increasingly difficult to select and advise clients on specific stocks. With so much uncertainty as to the ongoing direction of pricing and just how soft things might get, but with an expectation that we may never see hardness in the market like in the past, the analysts job is not going to get any easier.

There is one other area of the market where investors might find value creation. ILS and reinsurance capital managers.

Many of the ILS fund managers are constantly evolving their business platforms, adding access to new vehicles, new markets, expanding origination, building platforms to access Lloyd’s of London reinsurance market business, looking seriously at primary insurance or already providing risk capital to it, taking on complex weather risks, seeking to directly work with corporations seeking risk finance and exploring emerging market risks as well.

Which leaves one wondering. Would investors that like to hold stocks on the insurance and reinsurance sector be better off backing ILS players, there are of course a few stock exchange listed vehicles, and seeking to access the returns of the insurance and reinsurance market without all of the credit risks associated with a traditional re/insurance player?

If value creation is what you seek from investing in insurance and reinsurance, as well as a stable return, increasingly that is going to be available from the ILS space as it grows and the larger ILS fund managers expand. If there was a way to measure value creation it might be found that ILS is creating value more quickly than the majority of traditional players.

Of course we are in the midst of a time of change and we fully expect the traditional insurance and reinsurance market to change their business models and adapt to the way the market is moving, as well as to seek to increase efficiency, lower expenses and leverage lower-cost sources of capital.

So in value creation ILS will not have it all its own way. As ILS players seek to create value, traditional players are going to watch these efforts closely and will try to emulate and disintermediate using their scale and expertise.

The end result? A continued convergence of insurance, reinsurance and ILS is definitely possible. When creating value it may be advised to take the best elements of all strategies, with the resulting business and strategic mix providing considerably more value than one which seeks to maintain the old status quo.

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