We are well into the new year now and it is likely that scalability will be one of the buzzwords of 2015 for the reinsurance market. In an increasingly competitive market, participants are looking to access more and better quality business at lower cost – having scale (whether achieved by way of merger and acquisition or some other means) is one way of achieving this. This is likely to drive a structural change in the market – if so, a key reason for this change will have been the availability of so-called alternative capital.
Hedge funds, pension funds, sovereign wealth funds, private equity firms and other institutional investors have invested in the insurance market for a while, particularly the reinsurance market. This investment of alternative capital has typically been channelled into the market through the use of cat bonds, sidecars, collateralised reinsurance products and other insurance linked securities (ILS).
In some cases, the investors have invested directly into a (re)insurer. In fact, there has been an emergence over the past few years, and a spike in the recent past, of hedge fund backed reinsurers. These reinsurers tend to target low- volatility underwriting business (as opposed to the higher- volatility business usually targeted by ILS products).
Such reinsurers will typically be sponsored by an asset manager who will manage the investments and have access to a free “float” (i.e. the premium income) which can then be invested in accordance with the asset manager’s investment strategy (subject, of course, to any relevant restrictions on, for instance, what assets can be invested in for regulatory capital purposes). These asset managers will also have access to more permanent capital as reinsurer will be a regulated entity with certain capital requirements.
In each case, the institutional investors are attracted by the ability to invest in risks uncorrelated to the financial markets, allowing them to diversify their investment portfolios, establish a more tax efficient platform to manage assets, and potentially earn better returns than if they were to invest in more traditional asset classes. The amount of capital coming into the market from these sources is pretty staggering. With the level of returns some investors have seen and the continued low interest rate environment, this level of investment will likely increase yet further. Goldman Sachs reported around 18 months ago that assets invested in reinsurance by non-industry investors have grown by over 800% in the past few years to around USD 45 billion. That is impressive growth by any standards. Since then, Guy Carpenter has estimated that the market has grown by a third to USD 60 billion.
A great deal of debate has revolved around the impact of this alternative capital on, in particular, the traditional reinsurance market.
The influx of this capital has undoubtedly resulted in a growing convergence of the insurance and capital markets. The alternative capital providers are making available products which effectively package insurance risk and allow it to be sold to capital market investors. In some cases these providers are adopting a familiar reinsurer model (albeit with a more aggressive investment strategy). There is also a sense amongst some reinsurers that “if you can’t beat ‘em, join ‘em”, resulting in new investment structures being developed to attract and manage third-party capital. This has generated a new income stream for them, as well as possible access to risks which they did not have the capacity to underwrite on their own and the ability to potentially cherry-pick the best risks for themselves.
This new capital is putting downwards pressure on pricing with the consequence of taking the edge off the insurance cycle and smoothing some of the peaks of the pricing cycles. It would be premature to announce the death of the insurance cycle but it may be that, in certain business lines at least, the cycle may become less pronounced over time.
Some see alternative capital as a threat to the traditional reinsurance market. Indeed, some in the market have commented that there could be a mismatch between the risk being underwritten and the capital backing it as the focus of the new providers is on returns and they may not necessarily be ensuring that risk is properly assessed, priced and supervised.
It remains to be seen whether these concerns will come home to roost. However, as well as declining prices, the 1/1 renewal season has seen terms and conditions loosen, including in property casualty treaties, in order to mask softening rates by disguising the true cost of the risk. Unmodelled lines have been “thrown in” to cat programmes in return for better pricing, but which may result in a disproportionately greater risk. Given the cautious approach to risk, alternative capital providers may take an unfavourable view, particularly if the risk subscribed to is rather greater than they had understood it to be.
However, there is an opportunity to be grasped here. This capital could be used to support new products covering emerging risks as well as to support the growth of emerging economies. The traditional market needs to make the case for this. In the meantime, what the traditional players do have is deep pools of underwriting expertise and this does set them apart from the alternative capital providers. In whatever form the alternative capital providers structure their investments, they will require underwriting expertise and this can be and is being provided in a number of cases by the traditional players.