Alternative capital and the reinsurance industry

With competitive pressures mounting amid soft pricing and low investment yields, the traditional reinsurance model is facing continuing challenges. Most notably, there is the surging influx of alternative capital, in the form of insurance-linked securities, sidecars, and catastrophe (cat) funds, which was valued at $64 billion for 2014 by one estimate. This figure may jump to $150 billion by 2018, according to panelists at Standard & Poor's Ratings Services' 2015 Insurance Conference.

Panelist Bryon Ehrhart, CEO of Aon Benfield Americas, said that alternative capital is having a "big impact" on the reinsurance industry, explaining that there's been a "substantial surge" in recent years, coming largely from pension funds, sovereign wealth funds, life insurance companies, and other sources trying to diversify their yield sources. A growing portion of that is coming from cat bonds, with $5 billion to date this year alone (with an expected $9 billion of new issuance in total for 2015), up from $8.6 billion in 2014, according to Gary Martucci, a director at Standard & Poor's. He noted that "investors are becoming comfortable" with the risk modelling for this asset class.

Standard & Poor's has a negative outlook on the reinsurance sector, citing soft pricing and the resultant weak earnings potential – even in light of the industry's strong enterprise risk management and strong capitalisation.

One trend of how alternative capital is being deployed speaks to the market's efficiency, said Nelson Seo, co-founder and managing principal at Fermat Capital Management. "From my perspective, alternative capital has hit the peak peril pricing…it's the long-term profit driver for the reinsurance market. With that going away, it'll cause the reinsurance market to get more efficient. Overall, things should just become more efficient and fair," he said. He cited one example, "Florida may have been overcharged in paying premiums for hurricane coverage for a long time and that's subsidised the rest of the world."

Amid all this new money, the reinsurance market continues to consolidate. Dirk Lohmann, CEO and managing partner at Secquaero Advisors AG, said that the reinsurance industry is a "very cyclical one", continually going through "waves of consolidation". He noted that "there's no barrier to entering the industry other than talent".

Another major topic of discussion for the industry is how investors gain comfort with modelling catastrophes. "How do you get comfortable with models, especially when you have new perils and a limited number of events?" said Gary Martucci, director, S&P. “Standard & Poor's analysts meet with modellers every year and ask questions about any revisions to those models, acknowledging that ‘models are an inexact science’”.

Looking out to the next few years, Martucci said the cat bond market will continue to grow as much as 20 percent, as risk models assess perils around the world and "probably be accepted by investors on a parametric basis. There's no reason to think this market is going away anytime soon."