A tricky line to get right

The insurance cycle may have stopped turning for reinsurers, according to Fitch. In its Global Reinsurance Guide published in September the rating agency warned the industry it faced a “potentially permanent erosion of profit margins on historically profitable products”.

Pressure from the scarcity of large losses, increased market competition and “sluggish demand” from reinsurance buyers were one thing; the alternative capital entering the market (up 18 percent in the first half of 2014, according to Aon Benfield) could be a longer term feature. As a result, reinsurers are looking beyond property catastrophe risks.

At Monte Carlo, Swiss Re, the world’s second largest reinsurer, said that it would look to write more casualty reinsurance business. Others are planning to do the same, according to Fitch.

“We’ve already seen companies shifting their business out of the property side, causing some level of increased competition in the casualty market,” says Brian Schneider, senior director of insurance at Fitch. The year is likely to see more rates decline, he adds.

The pace this happens and softness bleeds into casualty lines will be pivotal for the market as a whole, according to Fitch.

For casualty, there are a number of potential barriers that could slow the tide.

Most obviously, there is the long tail nature of the business, combined with the lack of industry-wide models and greater difficulty acquiring data. Lines such as workers’ compensation have proved tricky for inexperienced underwriters in the past, notes Daniel Malloy, executive vice president at Third Point Re, which since setting up in 2012 has concentrated more on casualty than property.

He says: “It can be a very difficult line of business, and people that dabble in it have been burned before.”

Schneider agrees: “It seems that casualty’s a trickier line to get right, and if you get it wrong it can blow up on you.”

The long tail does not just impact the attractiveness of the risk, however: it also affects the ability to secure business for new entrants. The time lag between report and payment of claims means increased scrutiny of reinsurers in the primary market.

Andrew Newman, managing director and global head of casualty at Willis Re, says: “Clients are discerning about who they buy casualty reinsurance from. It is not as simple as a reinsurer opening the shutters and waiting for an orderly queue to form. There are significant barriers to entry.”

Those that succeed in diversifying and expanding into casualty will be those able to leverage existing relationships, demonstrate expertise and prove that they are in for the long haul, he adds.

No defence

These hurdles are hardly insurmountable, however. For a start, reinsurers without expertise in casualty can quickly acquire it.

“They are not retraining property underwriters,” points out Nick Pascall, senior vice president, casualty, at Hiscox, which started writing casualty only two years ago. “They are hiring 20-year casualty reinsurance people bringing their Rolodexes full of brokers’ and clients’ contacts.”

Pascall himself was previously chief underwriting officer of American Safety Reinsurance and prior to that, head of casualty underwriting with Catlin Bermuda. A couple of experienced actuaries, meanwhile, can build a model fairly quickly, he says.

Players already established in other lines, such as Hiscox, and new players such Third Point Re, both suggest that a track record in casualty is not a prerequisite to writing business.

Perhaps more significantly in the long term, the entry of hedge-fund backed reinsurer Watford Re and others means it is no longer clear that the long tails in casualty lines are enough to put off alternative capital (see box).

So, what is to stop the erosion of rates in casualty reinsurance mirroring that seen in property cat business? “I don’t think there’s a whole lot,” answers Schneider.

To an extent it is already being seen. Willis Re’s 1st View renewals report in July recorded significant rate decreases not only in property but in casualty, with the latter falling by up to 20 percent. There is little evidence the trend has since reversed.

“It is not as simple as a reinsurer opening the shutters and waiting for an orderly queue to form. There are significant barriers to entry.” Andrew Newman

The increased capacity from reinsurers looking to increase casualty business combined with greater willingness on the part of primary insurers to retain risk, shrinking demand, is having an impact, says Matthew Ball, a director at Towers Watson: “It is resulting in a softening in reinsurance rates, with cedants, for example, negotiating better deals on ceding commissions on quota share treaties.”

It remains a buyer’s market, agrees Paul Markey, chairman of Aon Benfield Bermuda.

“Whether it is purchased as a means of capital protection or for other purposes, it is a great time for insurers to be utilising reinsurance in some of these areas. Reinsurance is a highly accretive form of capital, that can act as a proven hedging mechanism, and can also allow insurers to use their own capital for strategic growth,” he says.

Keep calm and carry on

For all that, however, it is not a terrible time for casualty reinsurers. First, the impact of the squeeze on the prop cat business is not all one way.

“The headlines occupying the reinsurance world are that the cat price is down year after year, but the primary companies in the US are in a very different environment,” says Malloy at Third Point Re. About half its business is auto and home-owner lines excluding property cat.

“Those companies need to cede that again because they are over-levered. If you’re a Florida home owners’ company right now, your property cat costs have lowered and life looks pretty good. But as they grow they need to buy more of our quota share.”

There are also lines that are proving more resilient to pressure on rates. Medical malpractice and professional liability are big lines of business for Hiscox, for example. It is some distance from the big US, nationwide P&C insurers who have driven the large increases in ceding commissions, according to Pascall.

“Our client base tends to be the smaller specialist companies,” he says. The impact of alternative capital is also easy to overplay—at least for now, he adds.

“We have seen some of the existing traditional reinsurers be a bit more aggressive and want to grow participation, but we haven’t seen our signings eroded because of a Watford Re-type entity or a new capital.”

Even more generally, it is too early to be very concerned. It might be a good time for buyers, but business it still profitable, says Newman. “The fact is casualty results have been good. This new flood of capacity is undoubtedly creating more competition and improved pricing for buyers, but we’re not at a stage that can be described as even vaguely close to worrying or reckless.”

Finally, for both buyers and the reinsurers themselves, with the challenge comes an opportunity to grow the market. The key will be innovation, says Markey, with product development around risks such as cyber offering new prospects for growth.

“In areas where there isn’t a large volume of data reinsurers are going to have to be creative and hopefully help clients solve problems,” he says. “Instead of all participants chasing the same business, hopefully we can create some new business.”

An alternative take

Alternative capital in casualty is likely to grow, according to Fitch. However here, too, there are reasons the impact on the market may be limited.

It is, for instance, questionable how alternative some of the alternative capital entering the casualty space is. The likes of Third Point Re or Hamilton Re, while hedge fund-backed and with an alternative asset strategy, are reinsurers writing business on rated paper as traditional reinsurers do.

It is a different business model from property cat insurance-linked security funds where the policy limits are fully collateralised, says Matthew Ball at Towers Watson.

“It’s still a traditional rated balance sheet and a traditional reinsurance model, but using an alternative asset strategy which is usually riskier in search of higher returns,” he says.

“There have been a number of new start-ups recently, but the business model is not entirely new.”

That view is shared by at least some of the companies themselves. At Hamilton Re, chief underwriting officer Claude Lefebvre says he considers it closer to a traditional carrier than an alternative player. It has an alternative investment strategy, but that doesn’t necessarily increase the volatility of its results, he says.

“We are fundamentally traditional in the way we approach our business,” he says.

On the other hand, Watford Re’s model, which re/insurance specialist stock broker Dowling & Partners Securities terms ‘Hedge Fund Re 2.0’, could “potentially be a game changer”, according to Newman at Willis Re.

Rather than a start-up tied to a hedge fund, it ties a hedge fund to an established reinsurer (Arch Re in Watford Re’s case).

“They take a mandatory quota share and therefore they have assumed premium in broad and diverse lines of business from the get-go. They are not entirely dependent on rapid organic growth, and their expense ratio becomes manageable because they have substantial enough premium ab initio.

“Their alignment with the hedge fund manager, meanwhile, gives them a competitive advantage in as much as they are building enhanced asset returns into the underwriting model,” he explains.

Nevertheless, Newman still has some doubts whether the long tail on casualty risks can be overcome to attract the volume of investment seen on the prop cat side.

“The thing that makes property cat attractive for investors over and above the returns is the ability to exit the risk promptly, whereas in casualty, inherent latency means if investors want to leave the tail has to go somewhere,” he says.

Added to that, casualty is not the only option for alternative capital looking outside traditional areas. Chi Hum, global head of distribution at GC Securities, a division of MMC Securities Corp, a US registered broker-dealer, points to the catastrophe bond protecting against storm surge risk it set up for the Metropolitan Transportation Authority (MTA) in New York after Hurricane Sandy left it unable to secure the necessary cover.

“The MTA deal was a substitute for insurance, not reinsurance, and that’s significant because the insurance sandbox is much larger,” says Hum. Here, he adds, alternative capital is not just a replacement, but can fulfil unmet demand. “Alternative capital is almost unlimited,” he says.