Considering alternative reinsurance
Alternative or ‘intelligent’ capital was one of the major talking points at this year’s Monte Carlo Rendez-vous, with such forms representing around 15 percent of the catastrophe reinsurance market. Discussions revolved around whether alternative capital would serve to complement or cannibalise the traditional reinsurance sector. Our roundtable discussed the merits and challenges of alternative forms of capital.
Are new reinsurance models emerging in Bermuda?
Charles Cooper: A number of models are emerging: the hedge fund re/insurance vehicle is developing, the insurance-linked securities (ILS) fund, the pure ILS, and even a hybrid ILS fund-reinsurance model—so there are three or four approaches.
Will a particular model emerge as dominant?
Cooper: No, I don’t think so. Looking at a continuum from the traditional reinsurer all the way to Nephila, I think you’ll find that most people at this roundtable end up somewhere along that line. No dominant model has emerged.
Kathleen Faries: We’ve taken a slightly different approach to most. We have become a facilitator of the market and we’re going to continue to expand that service provider platform. It’s interesting for us because we get to see what a lot of these players are doing, and have watched the evolution of the market over time. A lot of collateralised reinsurers start out writing industry loss warranties (ILWs) and cat bonds, and now a lot of players are trying to move into the ultimate net loss (UNL) or traditional reinsurance space. That’s when it’s going to get very interesting because it’s a finite space. Certainly, it’s going to have an effect on traditional reinsurance.
Cooper: The one advantage traditional players still have over the ILS funds is access to business. We are able to provide a more comprehensive product that is more useful from an AM Best standpoint. What the ILS funds are trying to figure out is a way to tap into that business and improve their product to transform the traditional space.
Faries: I think the key to this are the reinstatements, because alternative players have to find a way to do that efficiently. If they have to put up two limits of capital then it’s just not efficient. It’sinteresting to watch how it’s evolved and is getting closer to the traditional model.
Kean Driscoll: From our perspective it’s all about providing solutions to customers. We’ve got Alphacat Re, which is an internal dedicated managed account. Through this arrangement we have deployed multiple sidecars over the last two years, as well as PAC Re, a joint venture with third party non-traditional capital writing on rated paper. We’re at the tip of the spear right now in terms of the potential for capital to enter the reinsurance space and we’ve got to be defensive and proactive in our response to that.
"We have deployed multiple sidecars over the last two years as well as PAC Re, a joint venture with third party non-traditional capital writing on rated paper."
We’re not 100 percent sure how this will manifest itself in the marketplace, but we’d rather control our own destiny and evolve as the market evolves. With respect to the dominant model I think that’s a difficult question to answer—for the reasons Charles and Kathleen identified—customers dictate the type of product they want to see. In some cases that will be fully collateralised limits, in others the reinstatement limit will mean a contingent capital model is more attractive and more helpful.
From a rating agency perspective what’s the view on new forms?
Robert DeRose: It’s a good thing that capacity is coming into the marketplace and that investors are interested in the reinsurance market, but it’s a negative that there’s already excess capacity in the marketplace. Additional capacity is likely to suppress forward pricing momentum. That’s one of our major concerns—reinsurers need to make an adequate return on capital. A lot of the publicly traded reinsurers are trading at a discount and that restricts financial flexibility.
The only way investors will be attracted to the market and publicly traded companies is when they are able to generate sufficient return on equity. Bringing additional capacity into the marketplace when it already has an excess is only going to diminish that potential. We don’t tell cedants where to buy their reinsurance or what structure to purchase. They simply present their risk management strategy to us and we evaluate their strategy based on its merits; from that we determine how much credit we give them against their capacity.
Will this usher in the end of bricks and mortar reinsurers?
Marty Becker: This year we’ve had more start-ups than we’ve had for a while and they have been non-traditional in nature. Every trend has its intentional and its unintentional consequences, and one thing that’s coming out of this current trend for alternative capital is the bifurcation of pricing cycles between property cat and everything else.
"One thing that's coming out of this current trend for alternative capital is the bifurcation of pricing cycles between property cat and everything else."
In the past, we went for long periods without significant rate changes and spoke of a $40, $50 or $60 billion property cat year being the catalyst required for a change in the cycle—last year, the industry saw $100 billion of insured losses, and property cat rates improved by about 15 percent over three months. In response you hadseveral billion dollars of new alternative capital come rushing into the space, taking the top right off the property cat market. Rates on other lines hardly moved over this period. In the near term, I suspect the alternative capital phenomenon will continue to grow, mainly because of the limited array of investment choices elsewhere in the world. These days, there’s just not many places to put your money if you’re hoping for a significant return. Property cat reinsurance looks unusually attractive at the moment, mainly because of the lack of recent significant US losses. Who would have thought Florida would go seven years without a major hurricane?
The challenge for traditional reinsurers is how to participate? Most of us are participating in some way. On the one hand, it’s harmful to our business, because it takes away some of the traditional pricing power that we had; on the other hand, most of these vehicles require infrastructure or services from traditional reinsurers. As a single player in the market you don’t really have a choice but to participate. You need to join in because, in some small way, it’s enhancing your business. At the same time, you’re probably taking away some future upside possibilities by enabling these alternative structures.
These alternative vehicles don’t have the regulatory costs you have— in a sense, they’re freeloading off more traditional players. The industry is going to have to evaluate what is a fair price for services delivered to third party capital. It also needs to consider how volatile this capital is. If, and when, a big event happens, will capital providers have the same appetite for these mechanisms that they seem to have at present?
Stephen Young: The traditional market is not going anywhere, although I expect it will evolve. Reinsurers have long-term relationships with clients that will last well beyond the short term dynamics ofthis industry. The traditional market provides a very specific product that is much more effective and well-rounded than short-term capital can provide. Collateralised limits look very expensive when you add a reinstatement into the mix, and long-term partnership models can provide underwriting and claim expertise and analytics that many of the new models simply can’t offer. Having that depth of expertise is of real value to our clients. So, no, I don’t foresee the traditional market disappearing—it will persist and continue to take advantage of new capital.
Faries: I think Marty’s point about the investment environment is important. Hopefully that does change and when it does, I think you’ll see a lot of capital that’s waiting on the sidelines move elsewhere. However, the pension funds will stick around because it’s such a small percentage of their overall investment portfolios and non-correlating
Cooper: It will be interesting to see if they reload post-event, because even if the event is relatively small, if it triggers a lot of these release clauses, a lot of capital could get trapped. For them to participate again they are going to have to reload—double down essentially. It remains to be seen whether they can do that.
"Whether alternative forms remain after an event, who knows, but I think it will be interesting to see what happens when interest rates return to normal levels."
A lot of these small ILS funds have been out marketing and explaining what the product is, and as a result there’s been a lot of institutional buying in the cat bond space. At the same time investors faced a troubled interest rate environment. 2008 proved the non-correlation argument that everyone had been telling investors, with cat bonds performing remarkably well during that period. In 2010 everyone was circling for yield, while the pricing environment was relatively attractive. When you add all that up, it was clearly an opportune time for investors to get in the space. Whether alternative forms remainafter an event, who knows, but I think it will be interesting to see what happens when interest rates return to normal levels.
Young: It’s not just about interest rates; it is about the price-to-book valuations of reinsurers. Today, much of the industry is significantly under-valued, and when that changes, the question will be, “What will happen to the market?” Will capital flow back into the traditional reinsurance model with buying of shares in stock companies? In today’s environment there’s no appetite to start up a new reinsurance company without a viable exit strategy, because valuations are simply too low.
Becker: Although we have seen some start-ups, such as SAC Re and Third Point Re, it is a different model. That model is largely predicated on the assumption that these firms can write the liability side without making significant underwriting losses. As we’ve seen, Greenlight Re came out with a share price of approximately 1.3 times book value for its initial public offering, now they trade at approximately book value. It will be interesting to see how those models evolve, because we’re not in a risk-free business
What proportion of the market, the property cat space in particular, do you think alternative capital may take out?
Driscoll: Statistics are difficult to pin down, but if you take in the aggregate cat bonds, collateralised products and managed funds it’s somewhere around 15 percent. From when we started in 2005/6, that proportion has dramatically increased—it was probably closer to 8 percent then. We think this figure could potentially increase— the key will be buyer behaviour. Is demand meeting the inflow of capital? In certain segments of the market—retro for example—the portion of alternative forms is probably much higher; close to 50 percent is non-traditional capital.
As to whether alternative capital stays, we’re not convinced that the market is so huge that the dance card will be full post-event, but we do believe that the line-up will be different. We don’t believe that existing capital providers have a glass jaw or will quickly exit the market. From the conversations we have had, one of the most interesting takeaways is that folks interested in our market have a really good understanding of the reinsurance industry. They fundamentally grasp the concept of contingent capital. In a way it’s interesting, in a way it’s concerning, as it reiterates our expectation that further capital will flow into the market.
Faries: Going back to the numbers, Guy Carpenter estimated that alternative forms of capital reached $34 billion this year, against $240 billion of overall reinsurance limit. They expected that in 2015 that would reach $43 billion, so it’s not a huge percentage.
Driscoll: What’s often not discussed is the real value proposition in bringing in alternative forms of capital, particularly with different appetites with respect to returns. There are certain segments of the risk spectrum where alternative capital is a natural fit. There’s the low down, highly exposed, more volatile end of the spectrum—some of the working layer Florida business and some of the retro and aggregate products. Not all traditional markets necessarily have a huge appetite for that business, but the amount of capacity is certainly much shallower at that end.
At the alternative end, which is much more remote risk, lower probabilities of attachment and lower primary risk, it could be a natural fit with pension funds who are seeking out non-correlated risk but perhaps with lower returns. In most reinsurers’ capital models that’s probably a natural fit. On the remote risk side we haven’t seen a big influx of capital yet but that is a space to watch. There is not amassive appetite for tail risk given the way we operate and manage capital so I’d regard that as a pretty big opportunity and it may even open up the size of the marketplace.
Young: Alternative capital really only has a small scope, specifically Florida and retro and some very high cat bond layers, but it’s primarily US wind focused—maybe with a little European risk and some earthquake coverage bundled in. Outside the US, there’s little interest for these alternative sources of capital.
Faries: It’s all about return expectations. If you can find pension funds that are willing to accept more reasonable returns, then you can actually start to transfer some amount of risk.
Are there any places alternative forms of capital can’t go? Or will they be able to go there by piggybacking on the expertise and capabilities of traditional reinsurers?
Becker: It’s much more challenging for them in the long-tail world. Events there are much less easily modelled, much less predictable, and you can’t get your money in and out as easily. It’s interesting, in the short-tail world, that it seems to still revolve around property cat. For the foreseeable future, it is likely to be property cat that principally accommodates this kind of capital.
How do you think alternative capital will affect the pricing cycle?
Cooper: It is going to take the peaks and valleys out of the pricing cycle—they will be shorter and not as dramatic. Alternative capital may also put a bit of a floor on the pricing cycle, because I think post-event payback is not going to be as dramatic. Alternative capital is unlikely to write underpriced business for five or 10 years with the expectation that post-event you will be paid back for the business. Players will need to focus on a set price and profit for each underwriting year.
How has the dynamic between insurers and reinsurers changed?
Driscoll: You’ve got traditional independent third party-managed funds. They exist because there’s a difficulty convincing or explainingto third party investors in the aggregate that alignment with a reinsurer is a better solution than maintaining independence. Part of that is maybe the effects of how other segments of the financial service sector operate. There’s a real concern about conflict of interest and reinsurers putting their sub-optimal risk into these buckets of third party capital.
We’re spending a lot of time with potential capital providers explaining that fundamentally that’s a faulty view of the marketplace. To establish an independent third party capital manager and build up the analytical, research and operational capabilities is incredibly expensive and time-consuming and from our perspective it’s foolhardy and filled with peril. Alignment with a traditional reinsurer not only gives you better access to understanding the risk, but a much broader spectrum of potential risk to develop—better portfolios of risk, more diversified and better managed.
The important nuance with respect to the relationship between the buyer and seller is that if it’s flowing through traditional reinsurance channels, there is more assurance that can be taken by the buyers. They know the company and they understand the concept of continuity. When going to an independent third party manager all of that is off the table—these are new people who don’t necessarily have that relationship or experience. They’re very focused on getting their capital back quickly, which can be stressful because that capital can get locked up. I’m convinced that over time, more money’s going to flow through the traditional reinsurance channel and out of the back door into alternative pools of capital. They will act as a storefront window—traditional, non- traditional, rated and not-rated all open to consideration.
Young: We have a similar view and we already employ the quota share concept where, essentially, Endurance is taking in that cat risk on one side and ceding it to our quota share partners on the other. We find that we can better leverage our capital and expand our footprint, while not overexposing our balance sheet. At the same time we can enjoy sidecar economics, with overrides and profit commissions.
Is there any other approach now, or is this the way all Bermuda players will be heading?
Cooper: Everyone’s heading there in some way, shape or form— every Bermuda reinsurer probably has some form of quota share line- up. It’s a continuum from a source of capital standpoint, but the most efficient way for investors to get a broad, well diversified portfolio of cat risk is through a traditional reinsurer, simply because buyers are more comfortable dealing with us. After 20 years we’ve paid out some pretty significant losses, so reinsurers’ willingness and ability to pay has been proven. That remains to be seen on the ILS side.
What is key to ensuring the continuing vitality of the traditional model? Is it taking and embracing new forms? Is the traditional approach worth fighting for?
Young: It is absolutely worth fighting for and there are definitelyways we can differentiate ourselves. Certainly, the traditional reinsurance model will evolve over time to leverage some of this alternative capital coming in. From a ratings perspective, it will be interesting to see how that develops.
How are matters playing out from a rating agency perspective?
DeRose: The market’s going to do what the market’s going to do. It’s a supply and demand dynamic and capacity is a function of that. Obviously there’s concern about reinsurers being able to make a profit and we not only evaluate the capital strength of an organisation but its ability to generate earnings and grow that capital. We also evaluate their financial flexibility and part of that is being able to attract investors. The model is evolving and reinsurers—for better or worse—are embracing these third party capital providers and trying to figure out how to fit them into their business strategy and make them a profitable part of their business strategy.
What do you regard as the value proposition of alternative forms?
Faries: It is the expense model. We’ve got all the regulatory burdens such as Solvency II, and that’s expensive. Tokio Millennium Re runs all three models, which is costly.
Becker: It is very expensive. To the extent that we’re supplying services to these new forms of capital, we need to ask whether we are really charging a fair price. A lot of indirect overheads associated with a traditional vehicle are being borne by our shareholders. We all like the overrides and it’s nice incremental income, but does it really pass the test of fair cost accounting? The biggest strength of alternative forms is the certainty of being able to tap “just-in-time capacity” as and when needed. That’s what it’s all about in the property cat world. The traditional industry, in and of itself, might not be able to reload as quickly as some of these other vehicles.
Driscoll: If you’ve got alternative forms of capital, that will allow you to have a size and scale that you can bring to a discussion with potential partners and there’s a fair amount of value in that. Often people focus on the fee element, but I think they’re secondary benefits in terms of being able to offer more capacity than you would otherwise be able to. It makes you more important to your customer and I don’t think that’s ever a bad thing.
What proportion of primary business has shifted into the alternative space? Have you seen a shift and how marked has it been in the last five years?
Becker: Alternative capital has probably brought in a new client base. It has also enabled the industry to put out larger lines than it would have otherwise, because there are now different forms of capital to support that line. As a result, alternative capital has probably increased our market exposure and our prospects in terms of potential clients, rather than having cannibalised what we were already writing.
Driscoll: Stepping back and looking at the market as a whole, the number of customers exploring alternative forms of capital is increasing, but at a fairly slow pace. In the US there is strong awareness of the product, but in Asia and Europe market penetration remains incredibly small. The client perception there is that they’re satisfied with the existing product offering, so there is not a huge demand or desire to face some of the challenges associated with alternative forms of capital, and the complexities that need to be recognised and understood. There are frictional costs, issues with trust agreement and temporal issues when capital gets locked up, and these are concepts customers aren’t all familiar with. If they’re not motivated to understand, the market will inevitably grow slowly.
Young: Despite having seen significant sidecar capital entering the market this year, some of our long-term Florida clients actually placed more business with us, and we increased our capacity. For these clients, it’s about the relationship and the expertise that Endurance can provide as a traditional reinsurer rather than simply about acquiring short-term capacity from an ILS fund or sidecar. We think it bodes well for the traditional reinsurance model.
Faries: There is still interest there. Some customers and buyers would rather face a traditional reinsurer. Even if it is 100 percent collateralised, they would rather work with a rated entity.
Has Bermuda positioned itself well in order to play host to alternative capital?
Young: While Bermuda’s special purpose insurer (SPI) legislation is not viewed as a driver of alternative vehicles or capital entering the market, it has been helpful. With something like 23 SPIs established in Bermuda in 2011 and several more so far in 2012, Bermuda is certainly maintaining its competitive edge in that space.