Convergence: engage and differentiate
There is little denying the competitive spirit evident in the third party capital space at present, with nearly every Bermuda heavyweight getting in on the action. The issue remains availability of investor capital to pursue risk and the number of third party players looking to put that capital to work, and the number and value of risks that are finding their way into the convergence space.
While increasing numbers of cedants are considering the convergence route, the dynamics—like those in the traditional reinsurance market—are competitive. As Kathleen Faries, CEO of Tokio Solution Management (TSM) explained, “Conditions are extremely competitive at present. Rated reinsurers are trying to retain their market share, while non-rated entities are trying to grow theirs.” This has served to place considerable downward pressure on rate and return and created a challenging environment for third party players that are attempting to build a track record with investors and compete for capital.
Darren Redhead, CEO of Kinesis Capital Management, agreed that conditions are highly competitive, adding that by competing only on price, players will face a significant challenge. Redhead said that Kinesis has sought to differentiate its offering by product, but admitted that the industry as a whole is tending to compete on rate. By doing so, downward pressure is unlikely to abate.
Lixin Zeng, CEO of AlphaCat Managers, added that three factors are exacerbating the competitive dynamics of the space. “Insurers are retaining more risk and reinsurers’ balance sheets have strengthened, meaning that they have more capital to deploy, while there has been a significant inflow of third party capital.” Together they are heaping further pressure on most third party players as they look to establish and build a niche for themselves in a tough cycle.
Differentiate to thrive
In the face of difficult conditions players have had to find new and innovative ways to differentiate their offering. For Daniel Brookman, chief operating officer at Blue Capital, it has been through close affiliation with its parent Montpelier Re that the company has sought to set itself apart.
“Few independent fund managers have the track record, the underwriting excellence and the approach to risk management that we have at Montpelier Re,” he said. Blue Capital is also able to assign considerable resources and headcount to its underwriting and understanding of risk as a result of its close affiliation with Montpelier, he explained. And with investors looking for the best performers, “conditions favour any platform where the mother ship is Sarbanes-Oxley-listed in the US and the best practice is already here”.
Zeng spoke in a similar vein, arguing that Validus has an enviable track record in the property catastrophe space, “with demonstrable resources that we can devote to constructing a portfolio”. He explained that there are two key issues when looking to deploy capital into the reinsurance space—access to business and risk selection. When it comes to access to business, deal flows are based on long-term relationships with clients and brokers, partnerships that will prove a challenge for standalone insurance-linked securities (ILS) managers, he said.
“Validus is one of the largest cat writers in Bermuda. Through our relationships we get to see more than 90 percent of deal flow in the global broker network. In order to construct the optimum portfolio you need your opportunity pool to be as large as possible, as that is where you select risk.”
Enjoying a view of virtually the whole market—as Validus does—AlphaCat can consider the full spectrum of risks in order to satisfy the risk appetite of its clients. This capability is coupled with superior risk selection, said Zeng. “Analytics is extremely important to us—we have a dedicated 35-man team within Validus Research which enables us to consider more than $200 billion of transactions and fit that with the appetite of our investors.”
Redhead explained that Kinesis is looking to differentiate its offering to the market in three ways. First, rather than an operating as an open-ended fund, Kinesis raises money once or twice a year when it sees opportunities to deploy capital. “If we can’t deploy capital we would prefer to return it to our investors—it is something I am passionate about. Last year around 75 percent of ILS capital wasn’t deployed for various reasons, but we believe that choice should be with investors.”
Second, Kinesis “backs Lancashire’s DNA in specialty lines”, offering clients multi-class reinsurance products rather than the standalone property catastrophe coverage that’s typical in the space. Rather than buying eight limits for their coverage, cedants are offered a bundled programme by Kinesis, explained Redhead. This helps to add a little more return for investors, while presenting an attractive proposition to increasingly global and diverse cedants.
“Most of our clients have changed their buying habits to take these products and they typically suit less leveraged clients looking to bundle their reinsurance spend,” he said.
This leads to the third differentiator for Kinesis—its return profile. As Redhead explained, it is higher than the 4 or 5 percent typically sought by pension funds. “Our return expectations are typically mid-double digit as we are talking about a riskier portfolio.” By extending a different return expectation to the market, Kinesis is looking to set itself apart.
With many third party players affiliated with larger rated parents, many are exploring ways to complement and leverage capabilities at the parent. Faries explained that in the case of TSM, the company aims to complement the signings of Tokio Millennium Re (TMR) and act as a facilitator of transactions, not as a manager of third party capital.
“The market understands that there are two separate signings. TMR is not ceding out its own net book through TSM, rather we are offering additional, separate capacity for our third party capital partners. In that way, if TMR wants to increase its net line it is not going to jeopardise our counterparty line and vice versa,” said Faries. “We also provide customised aggregate stop loss products for our fronting partners that allows them to write ultimate net loss cover more efficiently.”
She explained that TSM is using TMR rated paper to facilitate trades for its fronted partners, whereas many others within the space are ceding out what they are sourcing and writing on a net basis in order to derive fee income. “In a less competitive and better rate environment the latter approach makes sense, but as returns shrink and supply of capital increases, this approach will become less and less attractive for most.”
Redhead said that Kinesis is taking a similar complementary approach to its business. “Others are taking a share of the existing portfolio the parent writes, whereas everything that Kinesis does has to complement, not be to the detriment of, Lancashire.” Kinesis does not write the same business as Lancashire, Redhead explained, rather its risk:return profile and cost of capital enable it to pursue business different from that of its parent. “If there is a specific market dislocation we might pursue the same business, but would come up with a pre-determined split before doing so.”
For Zeng, AlphaCat complements Validus’ offering through the type of insurance being offered and the return profile of those transactions. As he explained, Validus is not involved in the collateralised space and by offering such capacity, the company is responding to rising cedant demand for collateralised alternatives. AlphaCat’s risk appetite is also focused on remote risks, he explained, generating premium of single-digit rate on line.
“Structurally it is not very productive for balance sheet companies to pursue these kinds of risks because the returns are relatively low compared to the marginal capital requirement costs. Pension funds, however, want the uncorrelated return and a complement to their bond portfolio, so a single digit return is perfectly fine with them.” Zeng added that collateralised capacity is also allowing the company to take larger positions on remote top layers, “and by offering a more comprehensive solution it is possible to secure preferred signings and—to a lesser extent—preferred pricing”.
For Blue Capital the company is looking to differentiate its position by trading directly with the market through its ILS platform Blue Water Re, explained Brookman. The platform is licensed to write reinsurance, rather than using Montpelier as the fronting carrier. Brookman explained that Blue Capital “sees value to all parties by trading as a direct market”.
“When a risk is syndicated through the brokers they will show it separately to both Blue Capital and Montpelier Re giving us a broader segment of the market, while our ceding partners benefit from diversified counterparties,” he said. Blue Capital is also “able to benefit from co-participation risk through quota share arrangements—which allow us to incrementally add to the portfolio”—and this enables the company to diversify its exposure outside the US, something that is typically harder for standalone funds to replicate.
Looking ahead it is apparent that a number of factors will affect the activity of the third party space. First among these is the consolidation of reinsurance panels. As Faries explained, “As buyers shrink their reinsurance panels, what is concerning for some of the newer and smaller players is how do they get on programmes? It’s a relationship-driven industry, and this will be a challenge no different from that experienced by new A-rated players.”
Some may feel tempted to compete on price, while for those that don’t it may be a challenge gaining any traction. Further exacerbating the issue are traditional reinsurers strengthening their case to be on cedants’ panels, said Faries.
“Rated players are leaning on their broker relationships, longevity, and leveraged balance sheet. They are extending multi-year deals, private layers and expanding their capacity right across a client’s programme. They are doing whatever they can to keep their market share and maintain a reasonable profit given the overheads they carry.” Reactive moves by the traditional market will place further pressure on convergence players.
Another dynamic is the levelling off of investor appetite and questions regarding the sustainability of investor demand in the face of market-turning events, declining returns and an improvement in relative returns in other asset classes. Brookman was confident that investor appetite would be sustained and would prove less volatile going forward. He said that over the past six or seven years there has been a proliferation in the type of money entering the space, with investors targeting a broad spectrum of risk:returns, but that longer-term capital is now the dominant force in the sector—a factor that should drive down pricing volatility in the third party pace.
Zeng agreed that he is seeing less volatility in the space, adding “While market pricing continues to come down, it is levelling off because the returns in catastrophe reinsurance are approaching an equilibrium with respect to those generated by alternative investments in the broader capital market.”
The final factor is closer consideration of other risks. While property catastrophe risks predominate, it is apparent that the market is considering specialty and casualty risks more strongly. Third party players such as Watford Re are leading the charge, but developments are not without their challenges. Redhead argued that in most instances there simply isn’t the return on such perils and that there needs to be a robust intermediary that can act as a transformer of that risk. He added that he sees opportunities in bringing unmodelled perils into the convergence mix, but that dangers of correlation persist outside property catastrophe.
Faries said that there is growing interest among investors and reinsurers regarding the potential of the casualty-hedge fund model, but that such an approach carries its own particular risks. “As more investors become educated and interested in the space they will naturally look outside property cat, particularly as the margin shrinks. However, a focus on investment return is volatile, particularly without the underwriting income, and so I would question the longevity of such plays.”