The class that never was: 2023 reinsurers

The existence of a healthy ILS market appears have eliminated the franchise value of property-catastrophe business for investors, according to Dan Hofmeister of AM Best. 

The insurance industry in general and the reinsurance market in particular tend to be cyclical. Currently, the reinsurance segment is experiencing a hard market that has generated risk-adjusted returns not seen since 1993. Each reinsurer has its own unique set of opportunities, but the market has improved almost all reinsurers’ prospects for enhanced returns on surplus and capital.

What usually precipitates the change from the soft pricing part of the cycle to the birth of a hard pricing cycle is a large-scale loss, which manifests in significant underwriting losses and surplus erosion. This generates investor appetite to allocate funds to the reinsurance market to enjoy the benefits of the expected hardening of underwriting conditions and the resulting outsized returns. A class of startup reinsurers usually quickly forms to capitalise on the interruption in the reinsurance supply/demand equilibrium. Many of these new reinsurer formations merge or are acquired as the market cycle returns to the soft phase of the cycle as the supply/demand equilibrium is reached at a lower price level after the new capital is used. 

However, whether it’s the great fire of Glarus (1861); hurricanes Hugo (1989), Andrew (1992), or Ike (2008); 9/11 2001; or hurricanes Katrina, Rita, and Wilma (2005); reinsurance market shifts from soft to hard have historically incorporated the formation of many reinsurers that have become leaders in the market today—that is, until the current hard market cycle, which is noticeably devoid of new reinsurer formations. 

The elevated property-catastrophe activity since 2017 (after an extended period of relatively benign years), coupled with a substantial increase in secondary perils, caused reinsurance pricing and reinsurance contract terms and conditions to improve notably, continuing, albeit at a decelerating rate, through the June 1, 2024, renewal. 

Additionally, capital market volatility precipitated by quickly rising interest rates in 2022 resulted in a mark-to-market shock loss that significantly decreased available capital across the industry. Although the capital losses were viewed as temporary, rising interest rates meant reinsurers needed to generate substantially higher underwriting income to compensate investors for the risk being assumed, which led to a chaotic reinsurance market. 

The gap between reinsurance sellers’ and reinsurance purchasers’ expectations and assumptions going into renewal widened. This resulted in a generational hard reinsurance market that has persisted into 2024 and is expected to continue through at least 2025. 

Not the usual hard market 

This hard reinsurance market is different from many of the prior hard markets in that it was not caused by a single large loss, but by the accumulation of a series of property-catastrophe events, which led to significant underwriting losses and resulted in earnings events for almost all reinsurers. 

Ultimately, the hard market was driven by a generally unprofitable market from 2017 through 2021. During this period, interest rates were at historical lows and resulted in an abundance of capital for both traditional reinsurers and insurance-linked securities (ILS). With the low costs of capital, reinsurers pushed for business growth while driving margins down and attachment points to unsustainable levels. 

This all shifted in 2022, after another mediocre underwriting year. The industry re-evaluated underwriting positions as interest rate spikes drove substantial changes in market capital positions. 

The substantial mark-to-market losses on reinsurers’ balance sheets was largely viewed as temporary, as the duration of fixed-income investment portfolios remained relatively short. Most non-life, fixed income portfolios had an average duration of three to five years. Coupled with a capital cushion to allow them to pull to par, the mark to-market losses would disappear when each fixed-income security matured and face value was realised—barring any defaults. 

Fixed-income securities backing life liabilities have longer durations and are more sensitive to interest rate changes. The longer-term cause of the hard reinsurance market was the lacklustre returns over a prolonged period, with investment losses and higher opportunity costs acting as catalysts. 

Regardless of the causes and differences with prior hard reinsurance markets, the market has hardened and it will take at least a few years for pricing and conditions to soften. And, yet, no new reinsurers were formed to capitalise on the turning market. This was not for a lack of effort or talented executives, as some high-profile management teams publicly announced their intentions to form new reinsurers, while many more were rumoured to be seeking funding. Ultimately, none of the potential entrants have made it past the fundraising stage. 

Lack of venture capital interest 

Successful new company formations depend on strong leadership teams. Executives with strong track records have yet to see commitments from private equity or venture capital partners. AM Best has issued a number of preliminary credit assessments on business plans from high profile management teams, which have had similar difficulties in fundraising. Many of them note that large, passive capital investors (such as sovereign wealth funds, endowments, and pension funds) still have healthy levels of interest in the industry and have made commitments contingent upon management teams partnering with reputable private equity firms. However, private equity/venture capital investors do not appear to be interested in supporting startup non-life reinsurers. 

More competition and higher barriers to entry 

A few primary drivers could be behind the shift in private equity appetite. The first is the competition in the reinsurance market. Although many players restricted coverage with the market turning, the competitive landscape, both domestically and internationally, is still healthy. 

Despite the capital declines from investment losses in 2022, there were no material adverse credit outcomes that would have driven the opportunity for new reinsurers to enter the market. Some larger reinsurers were able to raise significant amounts of new equity capital to deploy in the hard market, creating a dilemma: investors need to be certain that a newly funded reinsurer will have a place in this market once it turns, otherwise it will be difficult to liquidate its holdings and realize profits or avoid capital losses. 

The scale and capitalisation levels of established reinsurers make it increasingly difficult for startup reinsurers to compete at historical funding levels. In the past, reinsurers could viably enter the market with $1 billion of new, unencumbered equity capital, consistent with typical levels that new companies are seeking today (and now even less in some cases). However, this capital is insufficient to enter the market in as meaningful a way as in the past. 

Assuming that companies could write as much as $1 of premium for every $1 of equity, 10 years ago $1 billion reinsurance premium volume would place a reinsurer in the 37th position on AM Best’s ranking of top reinsurers in the industry. Today, that same $1 billion of premium would place them at #47 (Figures 1 and 2). At the lower position in the market, it’s difficult to visualise what value a new company would meaningfully add to the market dynamic, and how it would be perceived when it comes time for private equity investors to exit their positions. 

On the other hand, many publicly traded reinsurers with established operating platforms could be invested in hard reinsurance market exposures with less operational risk. Although returns for successful startups have been better than those for established players, recent IPO data suggest that startup capital is better suited for other sectors of the insurance value chain. 

Alternative entry points 

The availability of ILS makes the current hard reinsurance market a better opportunity for investors than prior hard market cycles. The ILS market offers a concentrated investment opportunity to supplement investments in large reinsurers that write global, well-diversified business and often primary and mortgage insurance, in addition to property-catastrophe coverage. 

The expansion of ILS capital began in the early 2010s, with assets now valued at nearly $100 billion (Figure 3). 

Over time, ILS products have been fine-tuned to attract investors. Most recently, the market experienced a material expansion of investments in the cat bond market, given that the property-catastrophe reinsurance market has benefited from significant hardening of rates and terms. An estimated $8.2 billion in new cat bond issuance in second-quarter 2024 contributed to the segment’s record issuance of $12.6 billion through June. These cat bonds allow investors to participate in the market’s strong rates while limiting investment time horizons. 

Investors currently have the opportunity to access exposures to the hard property-catastrophe reinsurance market through either established ILS products or large, well-diversified balance sheets of rated companies with proven risk management platforms. These factors have diminished the attractiveness of startup reinsurance investment opportunities, where capital can be committed for at least a five-year time horizon in an unproven platform, despite high levels of startup capitalisation and experienced management teams. 

As seen from startup reinsurer formations during the soft reinsurance market pricing cycle that lasted roughly a decade starting in 2008, new formations focused primarily on writing casualty and specialty lines of business, usually matched with a partial alternative investment strategy. 

The way to whet investor appetite during this period of anaemic property-catastrophe rates and terms and conditions, coupled with historically low fixed-income investment returns, was apparently to bring a credible solution to the market in the form of a total return reinsurer. Total return reinsurers, despite lacklustre performance, attracted capital and represented a logical response to conditions in the reinsurance industry and the capital markets at the time. 

The existence of a healthy ILS market appears to have diminished the franchise value of property-catastrophe business to investors. Investors today appear much keener to allocate funds to shorter-term ILS instruments to capitalise on the hardened underwriting conditions, rather than in a rated balance sheet. As long as these alternative entry points exist, we don’t foresee capital flowing into the new reinsurers to support hardened property rates and conditions. 

Rising risk-free rates 

Perhaps the most significant deterrent to investor capital for startup reinsurers is the precipitous rise in risk-free rates. Since the start of 2022, 10-year Treasury rates have nearly tripled, with credit spreads also widening. This raises the minimum rate of return that a new company would need to justify investor risk. 

Additionally, a new reinsurer would probably be writing property-catastrophe business to capitalise on market conditions, which inherently carry volatile earnings, thus requiring a heightened risk premium for investors to find the potential return attractive. The expected return required to attract investors to address the liquidity, volatility, and operational risks associated with a startup reinsurer remains elusive. 

Even with experienced management teams which have proven track records, how sustainable are the currently favourable reinsurer and capital market conditions compared to the required typical holding period of new reinsurer capital commitments? After several years of the current hard market cycle, the time horizon to launch and fund a startup reinsurer is narrowing—which benefits the existing rated reinsurers and ILS market participants. 

New company formations typically experience challenges dictated by market conditions and investment opportunity costs. These factors may not apply to all current opportunities, but capital has not yet flowed into the market to fund new reinsurer formations. It will be interesting to see whether any experienced management team overcomes these challenges to achieve their desired funding. 

This may become more difficult as the hard reinsurance market fades and softens, and fixed-income investment yields decline along with the expected decrease in the risk-free rate. New reinsurer formation is likely to decline as the established rated balance sheets and ILS market players reap the rewards of allocating capital to the reinsurance industry, enhancing their own operating returns and capital positions.

Did you get value from this story? Sign up to our free daily newsletters and get stories like this sent straight to your inbox.