Statements which say that third-party, or alternative, reinsurance capital is temporary and will likely depart the reinsurance market at the first signs of stress are misguided, according to Aspen Capital Markets MD Brian Tobben.
In an article posted to the Aspen website Tobben explains that portraying third-party capital as temporary, so as either hot or dumb money as it is often written, is not seeing the value of this capital and not understanding the motivations it has for being in the reinsurance market in the first place.
The traditional reinsurance market needs to accept that non-traditional reinsurance capital, which has been flowing into the market rapidly this year, is not destined to leave, according to Tobben. Incumbents need to accept that this new capital is here to stay and should embrace and seek to leverage the lower cost of capital it provides.
Many commentaries about third-party capital in reinsurance focus on investors hunting for yield. Tobben says that this is just part of the story and that the benefits of diversification are the stronger attraction for capital market investors looking at the reinsurance space as an asset class.
Returns from the insurance-linked securities (ILS) asset class, from instruments such as catastrophe bonds, collateralized reinsurance and sidecars, are not economically driven, explained Tobben, couple this with ILS’ outperformance as an asset class through the credit crisis and it’s easy to see the attraction to institutional investors.
Tobben said it would not be a surprise to see a dip in investor demand for catastrophe risk temporarily, but the long-term trend is towards further growth in third-party capital in reinsurance.
Investors in ILS and reinsurance are characterised with a more persistent appetite and a lower return target now that ILS has begun to mature as an asset class, said Tobben. Since catastrophe risk is not economically sensitive and is not a peak peril for the broader investment market, these investors can accept a lower return than has typically been accepted by traditional catastrophe reinsurers.
Tobben explained; “Contrary to some opinions, this new capital is not pricing catastrophe risks irresponsibly, but simply reflecting their lower cost of capital for a diversifying risk.”
This is the key point to note for those avoiding the trend to leverage third-party capital within their reinsurance underwriting and programs. The fact that the cost of capital is low due to the diversification benefits is also further exacerbated by the lower frictional and expense costs that are also associated with the ILS and collateralized reinsurance manager market.
Tobben continued; “Another way to think about this is capital impairment post event. A large catastrophe event will be a greater loss as a percentage of assets for the reinsurance industry than it will be for the pension fund industry.”
The influx of capital from investors into the catastrophe reinsurance space has resulted in a change to the pricing cycle, it has been both shortened and muted, said Tobben. Access to capital has been streamlined as well as coming with a lower cost, meaning that the peaks we had seen previously are not so evident today.
Of course we do not know how pricing will react after the next large catastrophe loss event which wipes a large amount of capital from the market, but it does seem likely that the replenishment of capital will be swifter and from lower cost sources today than it was even a few years ago.
Tobben said that reinsurers cannot stand still in the face of this competition. Embracing alternative capital can enable reinsurers to make best use of underwriting abilities and enhance their operational flexibility. He sees three main opportunities for reinsurers to benefit; first by lowering the cost of capital for peak risk through use of the ILS market, second by using instruments such as sidecars to strengthen relationships with key clients and to provide larger line sizes and third by managing third-party capital, generating fee income in return for risk management expertise.
While reinsurers stand to benefit from embracing third-party capital, Tobben notes that clients stands to benefit the most from the new market dynamic. More efficient capital leveraged by experienced reinsurers will result in both new and broader product offerings and combining the strengths of traditional reinsurance with the lower cost of capital from investors will bring benefits both to the customer and reinsurer.
Aspen Capital Markets recently launched its first sidecar vehicle, Silverton Re, which will allow investors to access the returns of its catastrophe reinsurance business. Tobben’s comments show that Aspen will be seeking to embrace third-party capital and the firm clearly sees it as an opportunity to allow it to better serve its clients in the future.
Read Brian Tobben’s full article on the Aspen website.