ILS ‘inflicting pain’ on the traditional market
Share prices in the Bermuda re/insurance market have declined since the start of 2014 following an extended rally, reflecting a difficult renewals and troubled industry fundamentals, further exacerbated by ILS capital.
That is the view of Michael Zaremski, equity research analyst at Credite Suisse, who tells Bermuda:Re that “it has been tough to positively spin the renewals or the fundamentals of what going is on in the reinsurance sector”.
Zaremski says that the recent pullback in share price reflects the pricing environment and underlying economic headwinds facing the sector.
Rising levels of convergence capital entering the sector have created particular difficulties and has led many reinsurers to “inflict pain upon themselves”, says Zaremski.
“30-50 percent of ILS capital competes with traditional capacity and for the most part the ILS sector has offered cedants coverage that is around 15 percent cheaper than traditional reinsurance. This is inevitably impacting industry economics”.
Zaremski says that market participants have established ILS funds in order to tap into that market and have sought to segregate them from their traditional underwriting, but in doing so they are all too often inflicting damage on their own core portfolios.
When considering developing third party vehicles “reinsurers need to calculate just how much growth will lead to core deterioration”, says Zeremski. “If you take RenaissanceRe—which is the largest third party platform on an absolute basis—they have not grown their ILS capabilities significantly in recent months in an effort to protect their own core business.”
He says that reinsurers will have to work out the optimum balance needed to develop their traditional core portfolio alongside their growing ILS arm, but adds that as yet “the equation has not worked in the favour of anyone in my universe”.
While growth among the largest ILS funds has slowed in recent months as ILS spreads have come down, helping to alleviate pressure on pricing, Zaremski suggests that reinsurers and third tier players may grow their platforms in response to the perceived opportunity. If they do, it will do little to change existing dynamics.
The position of property cat-focused players looks set to come under particular pressure, due to the syndicated nature of those markets and investor confidence in the model granularity and history available in peak peril geographies, says Zaremski.
While those with a third party platform are unlikely to feel any notable increase in investor confidence as a result of new distribution channels. “If we see a big event however, the ILS market could prove more significant than the traditional market in terms of raising capital. We won’t see start-ups and equity raises, rather it will be through third party funds”.
Commenting on investment-led players such as Third Point Re and Greenlight Re, he says they remain very much niche players, but there are opportunities for them to scale up. “We feel Third Point Re could scale up, easily tripling its top line and still be okay with AM Best and from an ERM perspective”. If this were to happen, others might be tempted to jump in, he adds, which would create a further competitive dynamic.
Looking ahead, Zaremski says that Bermuda market ROE is currently sitting in the high single-digit range, but is trending downwards. “We estimate that the industry is sitting on excess capital of around 10 percent of its share of equity and they will need to trim this if they want to improve their ROE”.
This will mean a willingness to cut their top line, but it is apparent that most companies have—despite market conditions—sought to grow their top line. “We were surprised by the extent of top line growth in 2013. Most reinsurance divisions grew by high single digits against the backdrop of a soft market”.
He says that some of that top line growth reflects the consolidation of reinsurance buying, which is tending to favour larger reinsurers, while among smaller players it reflects a pursuit of scale or a possible IPO.