Part I – The Market in the Developed Economies
A significant number of reinsurance treaties were renewed this month, heavily concentrated in property catastrophe coverage. It’s become apparent, however, that this market, for a number of reasons, has seen changes that have set it on new paths and perhaps into uncharted waters.
Analyzing why this has occurred is complicated, as each factor involved impends on all the others. While the increase in alternative capital is the most talked about, stronger balance sheets, greater retentions, technology, more sophisticated cat models, interest in emerging markets, new regulations, rating agency criteria, M&A activity, as well as a benign hurricane season in 2013, have all combined to produce changes for reinsurers that in all likelihood have forever altered the way they will do business in future years.
“New capital is driving down pricing,” said Mike Van Slooten, the head of Aon Benfield Analytics’ Market Analysis team, adding that as a result reinsurance buying has been reduced. He also cited the increases in reinsurers’ capitalization and the strong balance sheets some of the other factors affecting the re/insurance industry.
In its Reinsurance Market Outlook, published in January, Aon Benfield said: “Reinsurer capital grew 5 percent year on year. Demand for U.S. hurricane (the global peak zone) reinsurance limits from insurers was flat year on year. Reinsurance capital growth as a univariate continues to be less predictive than alternative capital flows and low real interest rates in reinsurance pricing algorithms.”
James Vickers, the Chairman of Willis Re International, pointed to several additional factors producing changes in the reinsurance market. “In the 1990’s the [earnings] figures were quite bad, but it wasn’t because the underwriters were stupid, they simply didn’t have sufficient analysis; therefore they had losses on business.”
That is no longer the case. Vickers explained that a combination of sounder economic management, increasingly accurate analytical tools – particularly sophisticated catastrophe models – the move towards “risk-based capital,” both as the consequence of increased regulatory oversight and as re/insurers adopted it as a better way to analyze their risks, along with pressure from the rating agencies, has caused major changes.
“Company management is more confident,” he said. As a result primary carriers “can retain more of the risks they write, and can look at buying reinsurance differently.” These new realities, combined with the flood of alternative capital into the reinsurance market have produced a significant rise in the capital available for reinsurance treaties and retrocessions, thereby lowering rates, especially property cat.
Willis’ “First View Report,” published at the beginning of January, said: “The impact of overcapacity has been most clearly evidenced by the up to 25 percent risk adjusted rate reductions seen on U.S. Property Catastrophe renewals at 1 January and the more modest but still significant rate reductions of up to 15 percent on International Property Catastrophe renewals.
“The influence of capital markets capacity is more pronounced on U.S. Property Catastrophe placements where a combination of traditional, collateralized and securitized capacity has been utilized throughout more program structures.”
Aon Benfield’s report described this combination of factors as having produced a “tipping point” for reinsurers. Van Slooten explained that the phrase includes all of the above, especially new capital. While the exceptionally low interest rates are a factor, it is also indicative of a “broader trend,” he said. “This capital will stay, plus there’s more to come.” As a result traditional reinsurers “will need to respond over the next five years.”
By Aon Benfield’s calculations, which are all inclusive, the aggregate capital in the reinsurance industry at the end of Q3 2013 was $525 billion [around $322 billion by Guy Carpenter’s calculation], $45 billion of which represented alternative capital. Van Slooten said: “If the current trend continues an additional $100 billion can be expected in the near future. This will put more pressure on traditional reinsurers’ margins and leverage.”
That capital isn’t solely the result of the proliferation of insurance linked securities [ILS]. It also includes equity capital investments, a majority from pension funds. Van Slooten explained that they are very savvy investors, and, given the funds they have available [U.S. pension funds manage around $30 trillion] are examining alternative investments in detail. They are content to achieve a 5 to 6 percent yield, and the investments offer diversity for a relative pittance given the funds they have available.
These factors have combined to produce the tipping point, which could also be described as the point of no return; i.e. the reinsurance industry won’t be going back to prior years’ business models before the financial crisis.
Consider this: At the Monte Carlo Reinsurance Rendezvous in 2011 a majority of those attending were looking for across the board rate increases from the devastating catastrophes that had hit the industry. But, while rates rose in those areas actually affected, mainly Japan and New Zealand; there was no appreciable across the board increase. At the 2013 Rendezvous no one was talking about overall rates; they were concentrating instead on alternative capital and its potential effect on the industry.
Whether you describe it as a tipping point, or as James Vickers called it, “an inexorable trend,” new parameters will be guiding the reinsurance industry in the future. “Formerly reinsurance was mainly proportional,” he said, “based on pro rata relief.” As the cost of capital has increased, primary insurers are retaining more risk; “reinsurance coverage deals more with volatility with more for excess of loss coverage.”
Vickers explained that for both insurers and reinsurers the “cost of capital” has become a primary factor. “Lowering the cost of capital means you can make a better deal, plus you can diversify and obtain better reinsurance at a lower cost for each unit of risk.”
Aon Benfield’s report reached the same conclusion. It said: “The cost of reinsurance capital as a component of underwriting capital has declined materially for nearly every class of reinsurance over the last two renewal cycles. The most dramatic cost decreases have occurred in U.S. peak hurricane zones. We believe more instances of opportunistic reinsurance use will emerge in the near-term.”
The new realities pose a challenge for traditional reinsurers. “New capital will continue to come into the market, and interest rates will remain low; short term solutions won’t help,” Van Slooten said. The re/insurance industry must find alternative ways to make money other than their traditional products, and they have.
“Insurers have already found ways to enhance coverage offerings using reinsurer capital, including flood and terrorism, and the opportunities for creative and nimble insurers to generate growth through additional coverage options supported by risk transfer have never been greater,” Aon Benfield said in its report. “Various big reinsurers are focusing on their corporate business relationships and their technical expertise,” Van Slooten said.
Those are necessary steps, but they run up against the fact that, as Vickers said, “there’s very slow growth in mature markets.” Those markets are in developed economies, where, as Van Slooten indicated, “property catastrophe reinsurance has become [similar to] a commodity product.”
Without growth the reinsurance industry will atrophy, but real growth in mature markets – given the present conditions – is almost impossible, if it’s confined to property cat. One reinsurer’s business increase simply means another reinsurer’s loss of that business: i.e. it’s a zero sum game.
Opportunities are there, if the industry looks beyond its established markets and comes up with new products to address new risks, or even to further explore old ones, including casualty and marine. Emerging risks, such as cyber liability and contingent business interruption, offer challenges, but rewards as well. Emerging markets have yet to really fulfill their promise for growth, but, if they are studied and the industry adapts to their needs, they will.
Part II explores some of the opportunities that need to be developed to provide places to put all of that excess capacity.