Some reinsurance firms that entered the year with lower overall levels of capital, following the impacts of the major hurricanes and other losses last year, have become ” increasingly dependent on retrocession and alternative capital to maintain gross capacity,” according to rating agency Moody’s.
This is another sign that the capital markets are becoming an integral piece of the average reinsurers capital stack, as companies have gone from purely using alternative capital for retrocession, to managing third-party capital in order to earn fees, to recognising the efficiency it can add, to now using it in order to maintain their own capitalisation, aware of the benefits its lower cost-of-capital has.
In a new report on the reinsurance sector, Moody’s said that with capital levels having been dented by catastrophe losses, “A few mid-tier reinsurers that are focused on property-catastrophe and specialty business held less capital at year-end 2017, increasing their dependence on retrocession to maintain underwriting capacity.”
Among the retrocession usage is a significant amount of alternative capital these days, with retro specialist ILS fund managers now providing the lions share of global retrocessional reinsurance capacity.
Despite the fact these retro focused ILS funds and vehicles were among the hardest hit by the hurricanes and catastrophes of 2017, they have been able to raise fresh capital in order to meet the needs of reinsurers seeking their support.
But as well as replenishing lost capital with funding from ILS and capital markets, reinsurers increasing use of alternative capital, particularly in their retrocession programs, is also a sign of a strategic move.
Moody’s explains, “This is in part due to losses sustained during 2017, but also reflects their deliberate strategy of using more retrocession, primarily backed by alternative reinsurance capital, as part of their capital base.”
In the last few years reinsurance firms have been bringing increasing amounts of alternative capital into their businesses for strategic reasons, both to lower their own blended cost-of-capital and also to enable them to compete with ILS markets for all-important peak property catastrophe reinsurance risks, Moody’s said.
The rating agency also noted that some reinsurance firms increased the size of their managed alternative capital vehicles after the losses, including ILS funds and sidecars, which Moody’s says has accelerated, “A shift in revenue mix toward fee income from managing third-party capital.”
This is a trend that Moody’s expects to continue, as reinsurers become increasingly adept at matching risks with appropriate forms of capital.
Here, Moody’s believes reinsurers goal is growing their top-line while keeping exposures in check, which is perhaps still more of a motivator than the fee income at this stage.
This will change, as reinsurers ability to manage third-party capital and deliver it the returns it wants improves, which is really a feature of their ability to identify where they should hold risks themselves, versus where they should pass it to alternative capital and take a fee for the underwriting and management services.
It will take time for reinsurers to become fully proficient here and along the way there will be pain as the fees earned may not be enough to compensate the underwriting effort, in some cases and areas of the market.
Moody’s foresees positive impacts from these trends, as “Increased use of alternative capital should boost reinsurers’ profitability by lowering their overall cost of capital.”
However the rating agency also warns that there are risks in embracing this strategy as well, saying, “Reliance on such non-permanent forms of capital increases the risk that these reinsurers may not be able to fulfil capacity requirements in the event of an unexpected decline in the supply of retrocession, or of affordable alternative capital.”
At the same time as the embracing of alternative capital continues apace in insurance and reinsurance markets there is also an expectation that investments in innovation, insurtech and efficiency will continue to.
Moody’s says that reinsurers recognise, “alternative capital is likely to cause a permanent reduction in profit for property-catastrophe business,” which supports our own theory that re/insurers will increasingly need to find other ways to monetise their intellectual capital and expertise in the coming years.
The increasing use of alternative capital has certainly been evident in the catastrophe bond market, which has started the year at record pace with $4.24 billion of issuance in the first three months of 2018.