The rapid growth of the convergence market, where reinsurance and the capital markets collide thanks to investors appetite for catastrophe reinsurance risk, has potentially significant implications for reinsurers, according to a report from rating agency Standard & Poor’s. While the growth of third-party capital in reinsurance is putting pressure on premium rates, it’s not all bad as the shift in the market could create opportunities for traditional reinsurers too.
The new report from S&P titled ‘Can Third-Party Capital Change The Property Catastrophe Market?’ contains the rating agencies view on the increasing flow of investor capital into the reinsurance market as it seeks uncorrelated returns and how this capital is changing the reinsurance market.
S&P says that the interest in property catastrophe reinsurance that investors are showing can be partly explained by the lack of opportunities in broader financial markets to achieve attractive investment returns. This makes investors look elsewhere, often at more alternative asset classes, and the U.S. property catastrophe reinsurance market is currently a very attractive alternative.
S&P says that the emergence of third-party capital reinsurance vehicles, which are designed to provide investors with direct access to the returns offered by insurance risk, could not only pressure rates in the traditional property catastrophe reinsurance market, but could also create opportunities for reinsurers to launch vehicles of their own.
This is the opportunity that we’re seeing in recent moves such as new sidecar launches, third-party capital markets divisions being launched at once traditional insurance and reinsurance groups and the burgeoning interest in the insurance-linked securities and catastrophe bond markets.
The growing convergence market gives investors access to the returns of reinsurance business through vehicles such as ILS funds, collateralized reinsurance funds, catastrophe risk vehicles such as sidecars, with the underlying investable instruments being cat bonds, industry loss warranties (ILW’s) and other reinsurance contracts. S&P notes that this growing capital market investor backed piece of the reinsurance market now accounts for as much as 15% of the more than $200 billion of property catastrophe reinsurance limits outstanding and as much as 40% of the retrocessional reinsurance market.
“The convergence market’s rapidly growing size has potentially significant implications for established writers of property catastrophe reinsurance,” commented Standard & Poor’s credit analyst Jason Porter. “This trend presents new challenges and opportunities as the convergence market takes an even greater market share, particularly in insurance deals that cover U.S. wind events such as hurricanes. And a number of traditional players have been able to harness these new capital flows by setting up third-party capital vehicles of their own.”
This is the trend we’ve been covering with increasing frequency here on Artemis over the last few years, as the influx of investor capital continues to flow into the reinsurance market. Noting that traditional reinsurance firms still have a chance to capitalise on this trend, Mr. Porter continued; “Companies that successfully create such vehicles may gain strategic benefits while earning a stream of fee income. But those that don’t may face increasing competition.”
Some traditional reinsurers are particularly at risk of being overtaken by collateralized and third-party investor backed sources of catastrophe reinsurance capacity, according to S&P’s report. Porter noted; “Catastrophe writers that serve merely as capacity providers, particularly to larger regional and national clients, are at the highest risk of being marginalized since cycle management may become progressively tougher.”
However the same trend is providing an opportunity to primary insurance companies, says the report from S&P. Porter added; “On the flipside, primary insurance companies that cede property catastrophe risk into the convergence market may benefit from the increased competition in the form of lower premiums, a more-diversified source of reinsurance capacity, and the ability to place larger reinsurance programs.”
So while rate pressure could mean lower premium returns for reinsurers as the market adapts to this ‘new normal‘ of third-party reinsurance capacity backed by capital market investors, it does also come with opportunities. Reinsurers who adapt to it best, often by launching their own third-party capital backed reinsurance vehicles and operations, stand to benefit from fee income and being early movers in the space.
This will enable traditional reinsurers to offer both third-party backed and traditional reinsurance capacity, the work here for them will be to identify where the best opportunities exist to deploy these types of capital. Of course this also means that traditional reinsurers need to work out how best to raise capital from capital market investors as well, and likely will mean the establishment of more capital market divisions within reinsurers.
Primary insurers have a clear opportunity to capitalise on lower rates created by the abundance of capital which has flowed into the space, and evidence from the cat bond market in recent weeks suggests that this could create attractive cost savings for those who choose to tap third-party capital for reinsurance cover now.
So it’s not all bad for traditional reinsurers and S&P’s report identified a number of ways to profit from the third-party capital trend. However they also offer the usual note of caution, that we have no idea how sticky this capital will be yet, particularly if interest rates and returns rise in other financial market asset classes. Porter said; “But the convergence market is still relatively young, and its staying power has yet to be fully tested.”
The other unknown is how the convergence and ILS market will react when a major loss is faced by investors. S&P says that volatility will likely emerge infrequently but perhaps in large doses, caused by high-impact, low-frequency catastrophe events. Again, we will have to wait and see how investors react.
You can access the full report via the S&P website, registration required, here.