Theory reinsurance capital is highly fungible challenged: Vickers, Willis Re

The theory that reinsurance risk capital has become highly fungible in nature, which came about partly due to the advent and growth of the insurance-linked securities (ILS) market, has now been challenged, James Vickers, Chair of Willis Re International believes.

The reinsurance cycle was pronounced as dead more than five years ago, something many in the industry suggested was for the better.

Rather than what many termed the antiquated payback model, where reinsurers looked to recover after losses by hiking prices considerably. The model of charging risk commensurate rates, that covered the costs of risk, capital, expenses and a margin, was seen a more sustainable strategy for the industry in a world where capital was moving increasingly quickly.

But more quickly than the capital has moved, the industry appears to have reverted to type.

Now, recent reinsurance market conditions suggest that rather than being dead, perhaps the cycle of old was just dormant for a time.

Reinsurance pricing has spiked considerably and is expected to continue rising at the upcoming January 2021 renewals, some would say due to losses having been high and supply having been lowered. But still, reinsurance capital overall hardly feels scarce right now.

We haven’t seen a major erosion of capital, even from the COVID-19 pandemic. But we’ve certainly seen poorly forecasted losses and evidence that models haven’t been doing their jobs though.

More fundamental though, to the whole question of the reinsurance market cycle and whether it has returned, or is just different, is the question of profits and profitability.

Change is rife at this time across insurance and reinsurance markets, so it’s hard to make predictions for the future based on the now COVID impacted rate environment.

It’s also important to consider the potential that risk has been mispriced and the market giving away far too much for too little return in recent years, resulting in a correction.

So are we seeing the cycle return? Or are we just seeing a realisation in the industry that it’s given too much away and not been covering cost of capital, let alone cost of risk, expenses and a margin?

We spoke with James Vickers, Chair of reinsurance broker Willis Re’s International division, to get his views on market dynamics.

“A lot of new capital is coming in, some of it undoubtedly to support new business at more attractive rates, but equally, some of it to strengthen balance sheets in the face of back-year reserve development and potential Covid-19 losses,” Vickers explained.

“The split between these motivations is difficult to discern, but either way, we have arrived at a moment when it is essential for reinsurers to realise some underwriting profit, and they are taking steps to do so. In the current near-zero interest rate world, reinsurers targeting high single- or low double-digit returns on capital look very attractive to investors.”

The way the insurance-linked securities (ILS) market was impacted by an aggregation of catastrophe losses over the last three to four years, particularly the effects to the retrocession end of the market, is one of the factors that has driven rates, Vickers believes.

“Retro is another factor. During the recent softer market, reinsurers managed their net positions by buying retro, with at least half of it provided through ILS. But ILS has been badly hit,” he told us.

“Investors and managers continue to suffer trapped collateral following catastrophe losses, and face a potentially large challenge with further capital trapping due to uncertainty around Covid-19 losses.

“Given this uncertainty, many buyers will be extremely reluctant to release collateral at end of year, and will seek to roll it over, which means it cannot be used to support new business. Some fresh capital has been raised, but the retro market will not be as competitive, and therefore will be diminished as a lever to manage reinsurers’ bottom line,” Vickers said.

As that lever becomes less prominent in reinsurers strategies and they cannot all leverage third-party capital as a tool for growth, while absorbing the worst of their losses, reinsurance companies have had to refocus on profit it seems.

Because of this, the reinsurance industry has become more attractive to other types of investors again, with private equity knocking on the door of many companies and industry luminaries, so as a result we see start-ups and equity raises in abundance at this time.

Of course, the industry doesn’t really need a raft of me-too start-ups at all. We haven’t seen the capital destruction normally required to leave space for them all.

But, reinsurance is looking very attractive right now, which makes investors keen to return to the sector and repeat the wealth generation that has gone before (as that’s what it boils down to).

“Some reinsurers are now feeling much more confident that if they raise capital, they can service it adequately by delivering the return they have proposed to investors. We expect to see more capital raising utilising different types of structures, but the theory that reinsurance risk capital is highly fungible, and that fresh capital will flood in to suppress the hard market, is being challenged,” explained Vickers.

Is capital less fungible? Is the reinsurance market back in the cycle of old and was it just put on hold for a time? Or is it different this time around and has profit become a sufficiently large driver of motives to enable the sector to hold onto the rate gains it is now seeing?

Time will tell.

We’d suggest it’s different, rather than just a delayed upswing in the reinsurance cycle now kicking in.

As we’ve said before, the industry needs to not return to wild cycles of the past, but rather establish baselines in pricing where costs of risk, capital, expense and margins are all covered, over the longer-term to make the business a sustainable driver of profits.

How will this affect the cost of insurance? One of the benefits of the great softening seen over the last decade was a cascading down of value to insurance buyers themselves.

Unfortunately, they too need to be prepared to pay costs that enable a sustainable insurance and reinsurance industry to operate. So there’s likely to be some impacts, as we’re seeing in P&C rates at this time.

The real question is just how cyclical reinsurance still is, or not and whether this is just a big correction that will stick this time, or we’ll just dip back to another softening once stability is found?

ILS capital will have an effect here, once the industry stabilises and investor inflows return in greater numbers.

With many in the ILS market now talking about the development of the next generation of ILS investment strategies and risk transfer products, it seems likely ILS itself will undergo a bit of an evolution, that could result in a resurgence in time.

In the meantime, it is having less effect on reinsurance pricing and ILS players are being very supportive of the push for higher rates, as they look to ensure costs (of risk, capital, expense and margin) are covered for themselves and their investors.

Vickers told us, “Some of the routes of entry – collateralised reinsurance and sidecars, for example – have not performed well overall. In contrast, publicly traded cat bonds have done much better. They did not see a big valuation write-down in March, and managers’ positions could be sold to provide immediate liquidity.

“We see not a lack of interest, but a change in the way ILS investors will access the market, as they continue to refine their strategies to gain access to risk. Some reinsurance and ILS investors have been quite successful in attracting fresh investors; others have struggled to find new capital.”

This mixing of outcomes for the ILS market will continue while we have managers pushing for better ways to price, word and structure their businesses, as well as managers seeking to persist with little changes to strategy.

Everyone has discussed the flight to quality, size, track-record and other ways capital has begun to reorganise itself. Perhaps the next one is a flight towards innovation in ILS, or at the very least towards the next generation (in terms of strategy, not necessarily new).

But whether the reinsurance cycle has returned and reinsurance capital really has proven not to be fungible, is to us not clear yet.

Rather, it feels like right now the market is correcting itself and perhaps, once baselines are found where profits can be sustained, we’ll see in the coming months if and indeed how the fungibility of capital still matters in reinsurance and ILS.

There’s a very strong chance it will do and in fact we may have seen nothing yet, in terms of how the velocity of money can dramatically change risk markets.