Alternative capital causing stir in risk transfer market

The market is neither soft nor hard, rates are generally regarded as adequate and a status quo is reflected in the stable outlook given to the sector by all the main ratings agencies. However, if discussions at Monte Carlo are to be believed all that might be about to change. This year’s Monte Carlo Reinsurance Rendez-Vous was dominated by one theme—the impact of third party, or alternative, capital from pension funds, hedge funds and wealthy individuals. This capital now threatens the cosy equilibrium that has characterised the reinsurance market in recent years. Some argue it may even transform the sector.hideAlternative capital is not new. The first cat bonds were issued in the late 1990s and have grown steadily since. Sidecars were also developed in the 1990s, becoming a popular way to recapitalise after Hurricane Katrina. More recently, collateralised reinsurers backed by hedge funds have made their mark. But over the past year alternative capital has started to compete more directly with traditional equity-backed rated reinsurers. Low interest rates are driving pension funds and other capital market investors into the insurance space. The result has been fierce competition among capital market investors and reinsurers for the more profitable US property catastrophe reinsurance business. In the June and July renewals this competition caused rates to dive 15% to 20% for Florida property cat cover. According to Hannover Re CEO Ulrich Wallin, such rate cutting has changed sentiment in the market, making it difficult to say that underwriters are still holding the line for US property cat. THIRD PARTY CAPITAL Up until June traditional reinsurers had the upper hand. But alternative capital providers are now more comfortable with insurance risk and have lowered their return expectations, making third party capital more competitive. Aon Benfield estimates that an additional $100bn of alternative capital will enter the market over the next five years. Speaking at a press briefing in Monte Carlo, Aon Benfield Chief Strategy Officer Bryon Ehrhart said that alternative capital could soon account for 50% or more of the US property catastrophe market. Some question the ‘stickiness’ of alternative capital. Once interest rates rise, pension funds will reallocate their capital elsewhere, they argue. However the brokers and cat bond investors at Monte Carlo believe pension fund investors—which have some $30trn of funds behind them—are here to stay. According to Luca Albertini of Leadenhall Capital Partners, a specialist ILS investment manager, investors are not just looking for returns. He believes the move by pension funds into insurance is driven by the need to diversify. He also points to their increasing comfort levels and growing expertise. Some investors are beginning to resemble reinsurers in their ability to analyse a reinsurance submission and are increasingly able to take on non-modelled risks, he explained. All of the big four reinsurers at Monte Carlo acknowledged the negative pricing pressure arising from the increasing influx of alternative capital. They are resigned to further rate cuts for US property catastrophe business in January. Some also accepted there is the potential for increased pressure on other lines of business as reinsurers look to reallocate capital from competitive US property cat into other lines. One beneficiary from this reallocation of capital could be large corporate risks. Munich Re and Swiss Re are both showing more appetite for such business. However, Swiss Re, Munich Re, Hannover Re and SCOR are all predicting an overall flat or stable reinsurance market next year. They were quick to point out that alternative capital is currently only really competing for US property catastrophe risk, which has higher margins and is well modelled. The use of models and the involvement of alternative capital has seen property catastrophe risk become increasingly commoditised. For large diversified reinsurers, the affected business only represents 5% to 10% of their total portfolios and, they argue, is having marginal impact on their operations. Mr Wallin also noted that low interest rates are still driving discipline in the wider reinsurance market as most reinsurers target combined ratios in the mid-90% range or below. He sees no reason why underwriting discipline will not be maintained in the majority of the market. He also said that rate reductions for US property catastrophe business will be offset by increases in loss-affected lines, including Canadian and German catastrophe risk and marine. ‘COMFORT ZONE' While increased competition in property cat lines seems certain, the discussions at Monte Carlo centred on whether this new capital would expand beyond its current comfort zone of well modelled high margin peak zone catastrophe business. This answer is not clear. Despite the hype, there have been only around $4bn of insurance-linked securities issued this year. Total bonds at risk are at a record $17.5bn, according to Aon Benfield. In contrast, total global life and nonlife insurance premiums were $4.6trn in 2012, according to Swiss Re. Swiss Re estimates that alternative capital represents 20% of the US property catastrophe reinsurance market—the majority split almost equally between collateralised reinsurance and ILS, with Industry Loss Warranties (ILWs) and sidecars making up 2.5%. This alternative share is up from around 17% last year. ILS are close to levels seen in 2007, with most of the growth coming from collateralised reinsurance. Historically capital market investors’ return hurdles and preference for short-tail well modelled risk has kept them largely limited to peak zone catastrophe risk, mostly US hurricane. Today, even though return hurdles have reduced, capital market investors are still mostly fighting over a relatively small slice of the insurance market. Speaking at an ILS panel debate in Monte Carlo, Munich Re board member Ludger Arnoldussen said he was not scared by competition from cat bonds. “Reinsurance is a very efficient way of transferring risk that is not easily picked up by ILS,” he said. “ILS has not really developed much beyond natural catastrophe, mortality and pandemic risks—it has not been the most innovative space,” said Mr Arnoldussen. But some believe it is only a matter of time before ILS begins to cover non-peak zone cat risks. For example, brokers have been trying to structure casualty business to fit the ILS market. Swiss Re, which was early to embrace alternative risk transfer techniques, was also keen to emphasis the key strengths of reinsurers. At its media briefing in Monte Carlo it said that there has been increasing demand for the tailored solutions and value added service that only well diversified reinsurers can provide. Lloyd’s Chairman John Nelson summed up the situation in his presentation at the PricewaterhouseCoopers breakfast meeting in Monte Carlo. In his view, third party capital could be used to expand insurance and reinsurance into new risks and territories. But unfortunately it has arrived too early. Insurers have not yet drummed up enough additional demand. INNOVATION PUSH Bryan Joseph, Partner at PwC, thinks the new capital will push a ‘conservative’ insurance industry to innovate. Like the brokers, he believes there is scope for insurers to grow the market by meeting demand for new risks like supply chain and cyber, taking on more natural catastrophe and terrorism risk currently held by governments and stimulating demand for catastrophe cover in emerging markets. He also believes that further developments in data and analytics will make such risks more palatable to reinsurers and insurers. Whether insurers can find a way to stimulate demand remains to be seen. However, reinsurers and insurers are already tapping alternative capital sources to access retrocessional protection, which should reduce the cost of capital. All of the big four reinsurers have issued catastrophe bonds for risks ranging from catastrophes to pandemics. They are also already using capital market products to broaden their product offering. For example, SCOR said at Monte Carlo that it was looking to use third party capital to underwrite larger lines of catastrophe reinsurance to global insurers. Swiss Re said that it is offering reinsurance cover that can convert to a cat bond if pricing in the ILS market falls below a certain point. Reinsurers are also earning fees from managing funds on behalf of capital market investors. Hannover said it had done hundreds of such deals with collateralised reinsurers to match their capital to its clients’ risks—exposures that it would otherwise not have taken onto its balance sheet. However, there may be limits on reinsurers’ ability to re-package and warehouse risks before passing them on to capital market investors. According to Mr Arnoldussen, this ‘transformer model’ would not be viable on a large scale due to issues with counterparty risk, transparency and legal risk.

Alternative capital causing stir in risk transfer market

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