Branching out

Diversification is nothing new for reinsurers, but as rates refuse to rise, reinsurers are looking to new lines for growth.

“As property reinsurance rates have fallen, there is certainly the desire to substitute higher margin business,” says James Votta, principal, Insurance and Actuarial Advisory Services at EY, who explains that in order to achieve a successfully diversified portfolio, reinsurers must use their own underwriting, accumulation and retro strategies.

He continues: “Certain industry segments, such as insurance-linked securities (ILS) and hedge fund backed property reinsurers, have seen tremendous growth and taken significant market share of the property catastrophe market. This segment may be reaching maximum catastrophe exposure and has looked to diversify in order to continue to grow.”

Votta says that the uncertainty in re/insurers’ current investment portfolios as they continue to acquire equities to counter low fixed income returns and protect book value in anticipation of an increase in interest rates, is also a factor, and that greater investment uncertainty could be countered with less volatile underwriting from an enterprise standpoint.

Votta goes on to explain that as property cedants continue to increase retentions—which adds volatility to reinsurers’ assumed exposures—this may also be encouraging further diversification.

“Studies of the US market indicate that cessions for property-related lines have decreased recently, while longer tail lines such as workers’ compensation and other liability cessions have increased. It’s pure economics and related to the underwriting cycle. Cedants will try and arbitrage the perceived relative pricing margins between their direct exposure and their reinsurance premiums.

“Cessions for property-related lines including multiple peril have decreased recently, while longer tail lines such as workers’ compensation and other liability cessions have increased.”

“So the drop in commercial property cessions in 2012 and 2013 foreshadowed the continued decline in property reinsurance rates in 2014,” Votta says. “Of course, economic theory can be upended by a systemic event impacting capital.” However, he stresses that most movement is being seen with the property reinsurers.

“Some of the hedge fund reinsurers are looking to expand their footprint into primary or casualty lines. For instance, Pine River Capital Management and Allied World Assurance Company are teaming up to build a casualty platform and Third Point Re has announced plans for a US operation,” he says.

“As long as the hedge fund companies continue to enjoy success in insurance and barring some new, better investment alternative, it is inevitable that they will expand deeper into the industry. This means more capacity will flow into casualty lines, just like we have seen for property. More capacity has historically translated into deeper soft markets and shorter hard ones,” says Votta.

Attractive prospects

The diversification and growth benefits of crop insurance have attracted primary and reinsurance writers alike, which is a trend that Votta says is likely to continue.

“In the US, 2013 direct crop premiums were approximately $12 billion and premiums ceded to commercial reinsurers were in the $2 to $3 billion range. Since agriculture is such a large part of many emerging economies, one would expect to see crop insurance products evolve in these locations. However, the same infrastructure, regulatory and cultural issues that need to be addressed by insurers entering these markets through personal, surety and other lines will need to be sorted out first,” he says.

Auto quota shares, professional lines and construction are also all experiencing increased interest from reinsurers.

“Many new reinsurers dip their toe into casualty business by first writing auto quota shares. We see some of the Florida ‘take-out’ companies employing reinsurance as a means of getting up and running with smaller capital needs.

“The relatively stable professional lines claims made experience has also caught reinsurers’ eyes. It also appears that improvements in workers’ compensation direct results have led to reinsurance activity,” explains Votta.

As the US economy continues to recover, primary insurance is coming back and the reinsurance will surely follow. We are already seeing some of this activity in construction classes.”

Votta says that with the exception of some troubled markets, such as New York and those states with Montrose-type statute of limitations, re/insurers have become more bullish on construction risks.

“Commercial construction in the US has seen positive growth in each of the last three years, following three years of decline. Housing starts have also shown recent growth. A strong construction economy should lead to better liability and workers’ compensation claims experience,” he says.

Emerging regions such as South America and Asia are also seeing heightened activity, but Votta says this is more likely to do with growth than a bid to diversify. “Some of these areas are seeing double digit premium growth that just isn’t there in established geographies.”

However, the market’s M&A activity is a much clearer shot at diversification.

“Much of the industry’s recent M&A activity has been aimed at diversification. A reinsurer’s biggest risk in venturing into new lines has to be getting the underwriting right. That means exposure identification, pricing and accumulation. We have seen a lot more underwriting managers and teams moving to new shops as companies try to get big fast through ‘free agency’,” he says.

“Wisdom has been forecasting consolidation within the reinsurance industry for over a decade, but particularly in Bermuda, we have not seen M&A at these predicted levels. I subscribe to the theory that the misalignment between buyers’ and sellers’ expectations is impeding the level of activity. But clearly, reinsurers in growth mode have not been shy about seeking out specialised underwriting talent or alternative product and distribution opportunities.”

But, as Votta explains, diversification is not just about underwriting, and while regulation such as Solvency II may encourage re/insurers to seek business in other lines, diversification for diversification’s sake may bring troubles of its own.

“In addition to underwriting fundamentals, there are outside motives for reinsurers to diversify. Every now and then we hear rumblings from the rating agencies about penalising insurers for a lack of diversification. Diversification for diversification’s sake can be disastrous, however.

“A lot of medical malpractice specialists found this out the hard way in the 1980s and 1990s.”

“However, I believe the industry is more sophisticated nowadays and the desire to grow and access more and more markets will continue to promote geographic, product and distribution diversification within the reinsurance industry.”

James Votta is principal, Insurance and Actuarial Advisory Services at EY. He can be contacted at: Jay.Votta@ey.com