Activity in the legacy insurance market has boomed. However, as capital pours in, perhaps it is best to understand how pricing will develop in the space and whether increased capital will drive price deterioration.
For a start, it is widely acknowledged that an abundance of capital in the live market has driven competition, constrained rate increases and resulted in a prolonged period of soft market conditions. While the live market has wrestled with these dynamics, activity in the legacy market has boomed. In addition, reports speculating that the legacy market’s ROE significantly outstrips live market returns have only served to compound investor interest.
The result is that capital from both traditional and alternative sources has flowed into the legacy sector. Established legacy carriers have raised significant funds to grow their businesses, and new vehicles have entered the market to assume risk—in many cases with sizable balance sheets to deploy.
Commentators have been quick to compare the scale of capital entry in the legacy sector to historic activity in the live market. In fact, competitive deal pricing and the market dynamic have been highlighted by executives as the biggest challenge facing the legacy industry.
Few would argue that the current market pricing dynamic favors the entities acquiring the legacy business. However, given the many variables that influence portfolio valuation, as well as the comparative scarcity of publicly available data points, it is harder to analyze legacy pricing trends than in the live market, let alone accurately predict the direction of their future travel.
However, what was less apparent in the data was the development of a specific, or pronounced, downward pricing trend.
There is no doubt that supply-led price competition is attractive to insurers that are considering ceding reserve risk. In fact, it is unlikely to be circumstantial that market inquiries for retrospective solutions have peaked while favorable deal pricing has been reported.
However, let us consider how the market derives transaction premium. When valuing a portfolio, reinsurers will consider, among other factors, reserve adequacy, reserve volatility, payout patterns, inuring reinsurance, claims handling, wider operational costs and the overarching “preferred” deal structure, such as attachment points, retention or limits. In addition, and fundamental to the reinsurer pricing model, is the capital uplift that an acquiring entity is required to hold to write the contract.
It is fair to assume that the established market participants will start with a more diversified portfolio than a new entrant. The implication of this, ignoring collateralized transactions, is that if a new entrant into the legacy sector has to deploy more capital, it would need to charge a higher price to achieve an equivalent rate of return on its investment.
Of course, those entering the market understand this and may be willing to accept lower returns to build critical mass. However, new capital is certainly not looking to assume business at a loss. It could even be argued that new participants are likely to seek strategic deals to build their operations stably, transacting these deals at a price that delivers their required rate of return, as opposed to “low balling” deals to win mandates.
Non-Price Deal Drivers
Importantly, price is not the only consideration when vendors/cedents assess the attractiveness of offers. Contrary to popular belief, in the majority of deals price is not seen as the most important transaction driver. Given the competitive nature of the live market, insurers are more than ever focused on reputational protection, deal-making competencies, flexibility of approach and claims management/operational pedigree.
In respect of these non-price drivers, the legacy market has spent the last two decades building its reputation as a safe haven for the insurance market to cede reserve risk. We would argue that these, as opposed to price alone, provide the key as to why interest in the legacy space has swelled.
Interestingly, we have also started to see a shift in the relative age of portfolios coming to market. The more “traditional” portfolios of mature asbestos- and occupational disease-related claims still underpin significant deal volume. However, cedents are increasingly seeking reserve solutions for less developed portfolios and, in many cases, looking to create capital efficiencies by releasing prior-year reserves from lines that they continue to write.
As the level of interest to cede reserve risk develops, potential deal volume increases. Now, having more rather than fewer markets becomes a significant advantage. A wider range of participants diminishes concentration risk and allows counterparties to develop their own specialisms, tailoring solutions to meet the strategic requirements of the live market. Of course, price remains a factor, but it becomes much less of a determinant than the expertise, strategic support or partnership approach that the right legacy partner can offer.
Risks to the Market
Although the legacy market is generally resilient and diversified enough to absorb losses, in our view the biggest risk the industry faces is the regulatory failure of one of the major legacy markets.
The legacy markets will always seek to structure portfolio acquisitions in a way that minimizes their downside. However, there is often a significant asymmetry of information, meaning that not all transactions can be profitable. Recent vendor preferences for ceding less developed business, as referenced above, is likely to have an increased impact on earnings volatility and, as such, there is a greater potential for “unknown unknowns” to be transferred from live to legacy balance sheets.
It could also be argued that those acquirers who raised private equity capital may find themselves under greater pressure to deploy funds than traditionally capital backed vehicles. One outcome of this dynamic is the risk of increasingly aggressive pricing strategies being used as a tactic to increase the chance of executing a trade.
It is important to remember that this risk is limited by a number of factors. Firstly, as we have already mentioned, investors do not want to write business at a loss. Secondly, insurers, regulators and advisers are all likely to take a more critical view toward significant price outliers in any transaction. However, should overly aggressive pricing behavior become endemic within the market, the question to ask is what level of premium deterioration could cause a systemic issue?
What Does the Future Hold?
There is clearly appetite in the live market to explore a wider range of retrospective transactions. This appetite has been whetted, not only by the short-term commercial terms available but also the development of established and well-respected counterparties to support the long-term interests of the insurance industry.
We have seen major global insurers becoming serial disposers of portfolios, activity that has not gone unnoticed in the eyes of their competition. As a result, we are increasingly seeing larger insurance groups (who hold significant reserve volumes) consider the benefits of legacy transactions. On the other end of the scale, an increase in inquiries from smaller insurers looking to improve their capital position gives rise to opportunities to suit a variety of balance sheets.
In addition, with legacy specialists looking to make deal origination as efficient as possible, we may well see an increased focus on trying to develop longer-term strategic partnerships between legacy and live market participants.
Given the competitive nature of the market, retrospective placements are always going to be driven by the economics of the transaction. Ceding insurers must demonstrate the economic value of a trade to their stakeholders in the same way that the acquiring markets must do for theirs.
However, successful deal execution is based on so much more than the quantum of the premium, with long-term reputational protection being the foundation that the legacy market has been built on.
As this message continues to proliferate through the industry, we should expect market opportunity to continue to flourish on the basis that competitive yet equitable terms can be agreed by all.
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