Taking the plunge


The industry is adapting to a new norm, one shaped by the influx of alternative capital. Bermuda:Re asked the market: Are we on the cusp of profound change within the reinsurance industry as a result of increasing capital markets interest, and how will this change the dynamics of the industry?

Luca Albertini
CEO, Leadenhall

Capital Partners The majority of capital which is backing the capital markets’ interest in insurance-linked securities (ILS) and collateralised reinsurance is provided by pension funds. Pension funds made a strategic investment and are less opportunistic, are highly skilled and well consulted by skilled professionals. This capital base will prove to be stable provided the right relationship between risk and rewards is maintained. In my view the expanded capital base will (as it has done in the past 10 years) help smooth the reinsurance pricing cycle.

The great opportunity presented by this new capital base is to provide resources to reduce the gap between insured and economic losses, which is vast even in well modelled zones. Also, collateralised markets tend to look at tail risk, and a growing component of collateralised cover at the very tail will help increase the credit quality of reinsurance cover for remote events. Capital markets will become, in my view, more relevant in the layers where it provides most value (mostly one shot mid to high layers for modelled perils) and the reinsurance industry will focus more on the other layers and risk classes where it has appetite and provides value due to its bespoke approach.

Michael Popkin and Rick Miller
Co-heads of ILS, Towers Watson Capital Markets

The reinsurance market has recently undergone considerable change, but we remain closer to the start than the end of change. We are witnessing a shift from a clubby environment to a more effi cient pricing frontier, where reinsurance managers—whether ILS or traditional reinsurers—will have different pockets of capital for increasingly segmented risks.

We are seeing a greater democratisation of risk transfer. More cedants, through private placements, can access the capital markets for mid-sized deals done in indemnity form. Reinsurance managers will need both cedant relationships and the precise pocket of capital required to provide coverage in the right form for the peril and layer the cedant wants to transfer.

The most successful reinsurance managers will manage multiple balance sheets or mandates or funds, employ various strategies, and have the capacity to underwrite various layers, independent of format. Conversely, to maximise the value of the changes, cedants will need to become more agile and informed about the diversity of choice for reinsurance. In the end, the question for cedants will be which reinsurance managers are most effi cient for which risk transfer. The discussion about whether it is a traditional or a convergence player will become less relevant.

Brian Schneider
Co-head of reinsurance, Fitch Ratings

Fitch Ratings views convergence of the reinsurance and capital markets as here to stay and likely to continue to grow in the near term as powerful economic forces have driven the increased acceptance and use of capital market alternatives to traditional reinsurance.

The nature of property catastrophe risk being highly modelled and commoditised serves as an important economic force driving its transfer into the capital markets. Casualty re/insurance lines have had limited movement into the alternative reinsurance market so far, as the less standardised and more specialised nature of these longer-term risks makes them better suited for more permanent, traditional capacity providers.

Another important economic factor is the continued growth of investor demand for the alternative reinsurance sector as pension funds, other institutional investors and hedge funds have increased their allocations to this diversifying asset class.

Fitch views the growth and acceptance of alternative reinsurance as a mixed benefit for the credit quality of reinsurers’ ratings. Favourably, they can be used to manage reinsurers’ exposure and capital and serve as a source of fee income. Negatively, they represent competition for traditional reinsurers that, in conjunction with the strong overall capitalisation of the reinsurance industry, have worked to notably dampen reinsurance pricing.

Paschal Brooks
Executive vice president, portfolio manager, AlphaCat

Undoubtedly, the reinsurance market is evolving to address the opportunities presented by increased interest in the sector from the capital markets. However, the core operating principle of the business remains the same—delivering sound risk protection to reinsurance buyers in a way that provides an attractive economic return to stakeholders. While the sources of capital funding for the reinsurance market may shift over time, reinsurers will succeed based on the extent they deliver on this basic concept.

In the long term, the fl ow of new capital should encourage reinsurers to grow capacity, develop innovative products and extend protection to new risks. While this process may require experimentation and disrupt certain long-standing traditions in the reinsurance market, the resulting market solutions should benefit both investors and reinsurance buyers.

Steven Webersen 
Managing director, insurance research & consulting, Conning

"The provide a source of additional underwriting capacity to serve client needs and complement their own balance sheet. This allows the reinsurer greater flexibility with its own capital according to the underwriting cycle and provides a source of risk-free income in the form of management fees and profit-sharing income."

In our opinion yes, we are experiencing profound change, but it has been a fairly concentrated one affecting primarily the property catastrophe sector of the market. To put that into perspective, we estimate property catastrophe premiums account for about 12 percent of total non-life reinsurance premium. To us, what is most profound is the reaction and role that reinsurers are playing in this developing market. Among the major reinsurers, there are probably fewer than a handful who have no participation in the alternative capital space. The business model for many reinsurers is changing. Reinsurers are trying to offer alternative solutions for clients, such as collateralised reinsurance, without losing business to the capital markets.

So we are seeing a change in the industry’s dynamics. In addition to the widely reported effect that capital markets capacity is having on pricing, many reinsurers are effectively getting into the third party asset management business. We think reinsurers are very well positioned to compete, which is not to say the dedicated ILS funds are not. However, reinsurers have two important advantages— market access and resources, and expertise.

The question is often asked, ‘Is third party capital here to stay?’ To us the two determining factors will be: what happens following a large catastrophe loss, and will investors remain if and when interest rates return to more normal levels? Regarding interest rates, we think capital markets participation in reinsurance risk is less a function of current rates; the non-correlating nature of the risks are a key factor in why ILS has become a more accepted asset class. As far as a major loss, we think it is fair to say the market has not really been tested.

Yes, there have been some defaults but the market has not experienced a very large Florida or Northeast event for example. Time will tell. One other signifi cant consideration is that demand for these alternative products is very high. Pricing is attractive and buyers are attracted to the alternative source of capital they represent as well as the limited credit risk exposure.

Robert De Rose
Vice president, AM Best

Ironically, as investment and underwriting opportunities have waned, the reinsurance sector has attracted additional new capital to an already capital-saturated market. It seems that investors and money managers are enticed by the potential for relatively favourable returns offered by the property casualty (P&C) business. The P&C business, viewed as an uncorrelated asset class, also offers the potential for generating cost-free investment fl oat, which has an increased appeal to money managers when willing investors are diffi cult to fi nd. However, the key to cost-free fl oat is underwriting acumen, so investment managers have been courting good underwriters to form sidecar vehicles as a means to access the business.

The matching of underwriting profi t with a non-traditional asset strategy can, in theory, produce a relatively lucrative return if all the stars align. But where there is greater reward there is also greater risk and it remains to be seen how these strategies will work out over the longer term.

From the reinsurer’s (underwriter’s) perspective these sidecar vehicles offer an additional source of financial and operational fl exibility. They provide a source of additional underwriting capacity to serve client needs and complement their own balance sheet. This allows the reinsurer greater flexibility with its own capital according to the underwriting cycle and provides a source of risk-free income in the form of management fees and profit-sharing income. The downside is that more capacity only serves to keep pricing more competitive and the stickiness of this capacity is not proven. The traditional market has long prided itself on long, deep client relationships. Should this additional source of capacity decide to exit, the underwriter would have to do the explaining. It is this reputation risk that could place reinsurers in a diffi cult position.

AM Best, alternative capital, Conning and Co, Alpha Cat, Fitch, Towers Watson, Leadenhall Capital Partners

Bermuda Re