Alternative capacity - 10 burning questions
1. How would this capacity react to severe losses?
In the event of very big losses, for example thanks to a bad hurricane year in 2013 (which has been forecast), how would capital markets investors react? Would they remain committed or flee from the sector?
In an industry whose existence is based on long-term relationships and commitment through the good times and the bad, this could be key to the extent to which cedants are willing to use insurance-linked securities (ILS) and other structures such as sidecars if they fear that capacity will not be reliable in the long term.
The logic of why investors could flee is easy to follow. Bonds rarely completely default in the capital markets: sacrificing interest payments is unusual for investors, never mind losing the entire capital invested in the bond. But this is exactly what happens if a cat bond is fully triggered.
The idea that such scenarios would send investors running for the hills could just be wishful thinking on the part of the traditional industry, however. In fact, the opposite could be true. Investors in ILS products especially are now sophisticated and fully aware of the risks. In actual fact, they could even be keen to reinvest straight away—albeit at a slightly higher margin than before.
Paul Schultz, chief executive of Aon Benfield Securities, says the question of how these investors would react to a big loss is a common one. But he too believes they would be unlikely to be spooked. “Investors understand the risk and would simply look to reinvest,” he says. “Their appetite would not change and they would continue to support the sector.
“The only thing that would deter them would be if something unexpected happened—if a loss occurred that was outside their modelled expectations, for example.”
Others agree. “We have been involved in this market for a long time and we know that investors’ eyes are wide open and they understand there can be losses,” says Judy Klugman, head of ILS distribution & sales at Swiss Re.
“When they have taken hits in the past they have stayed. We fully expect that if losses occur they will still provide capital to industry.”
Klugman does add, however, that heavy losses could trigger a different type of pricing cycle for these risks, potentially disassociated from the reinsurance cycle. “The capital markets have their own cycles anyway and losses would certainly affect pricing. But it would not dampen their basic interest and there would be far shallower peaks and troughs,” she says.
Jonny Creagh-Coen, head of investor relations at Lancashire Group, agrees. Even if some investors did exit the market, he says, others would replace them. “There is a liquid pool of new investors just waiting to enter the market,” he says. “The capital markets are that big. And post-event they would be enticed by the prospect of an even better return.”
2. Will investors withdraw when the wider investment markets recover?
One of several reasons for the recent proliferation of interest in ILS has been the lack of decent investment returns to be found elsewhere. Interest rates have been at record low levels for several years now, making decent returns on instruments such as government bonds difficult to achieve. Meanwhile, the world’s equity markets have also endured a torrid time since the start of the financial crisis.
But if interest rates were gradually raised and if the wider investment markets improved (which must happen eventually), could investors also pull back from the ILS space and go back to more traditional investment products?
No, says James Vickers, chairman of Willis Re International, who believes the investors that have now entered this space are sophisticated and long-term in their approach to the market.
“I agree it has certainly been a unique market investment-wise for several years,” says Vickers. “Interest rates have been at rock bottom. What happens if that changes? It is a good question, but I believe this form of capacity is definitely here to stay.
“Fifteen years ago it was short-term in this space, but all the signs are that this is now a long-term strategy for investors such as via pension funds, which are by their very nature serious long-term players.”
Schultz at Aon Benfield Securities agrees that such a scenario would not lead to capital exiting the reinsurance space.
“Even if interest rates improved, that would not happen quickly and it would be hard to imagine capacity leaving quickly,” he says. “If rates also tightened, the lack of correlation between ILS and other investments remains very compelling to investors.”
3. As alternative capacity grows, where does that leave traditional reinsurers?
Some estimates suggest that around 30 percent of all global catastrophe risks (insurance and reinsurance) could be covered by alternative capacity within five to 10 years, representing up to $90 billion of what is an estimated $300 billion market.
Different firms and individuals roll out different statistics on this. For example, according to a report called Insurance-Linked Securities for Institutional Investors, published by Clear Path Analysis, this form of alternative capacity is already worth close to $30 billion.
The report arrives at this figure by adding together the size of the existing cat bond market with what it estimates is a similar sized collateralised insurance market. And it believes this will double over the next five to 10 years.
“The current market for non-life catastrophe reinsurance capacity is about $180 billion; this is essentially the total capacity purchased in the reinsurance industry by primary insurance companies,” said Michael Stahel, partner at LGT Capital Partners.
“Of this, the pure non-life cat bond market is roughly $14 billion. But add to that the $15 billion collateralised insurance market and it brings the total close to $30 billion. We believe that this number can grow considerably over the next five to 10 years and as a result, up to a third of the entire market— around $50 to $60 billion of capacity—may be provided by investors by 2017.”
Creagh-Coen agrees that it is certainly feasible that 30 percent of the market could be taken by capital markets capacity.
“The consensus seems to be that there is around $300 billion of direct property-cat business globally and the proportion of this being covered by alternative capacity is growing.”
“But the biggest question of all, as this market grows in size, is what would this mean for traditional reinsurers? This is unquestionably a concern.”
Creagh-Coen says for reinsurers that are not actively involved in this market, this would be bad news.
“For a traditional player, it means that a large portion of your dinner is being taken away before it even gets on the table,” he says. “And this would mean the revenues and profits of traditional players would both be under pressure.”
Darren Redhead, head of capital management at the Lancashire Group, agrees. Although he notes that it is unlikely in the near future that alternative capacity will move beyond cat risks and into other areas of reinsurance, he says the estimated $300 billion catastrophe risk chunk of the market is vital to many players.
4. Will investors move beyond peak risk cat risks?
So far, this form of capacity has been limited to participating in peak catastrophe risks. But could it start moving into other areas of the industry seeking new opportunities, both geographically and by new lines of business?
In fact, possibly the scariest statistic in this entire debate involves looking at the size of the capital markets globally compared with the reinsurance sector, especially the size of the catastrophe risk segment capital markets investors are so interested in.
Although it’s never easy to measure exactly, most studies suggest that the value of the global capital markets is now well over the $200 trillion mark. In contrast, it is estimated that there is around $300 billion of catastrophe exposure currently covered by either traditional reinsurers or ILS products.
It might, therefore, be natural to assume that investors will start looking beyond catastrophe exposures. Experts differ, however, on how this dynamic will play out.
Dirk Lohmann, the former chief executive of Converium who is now chairman and managing partner of Secquaero Advisors, an ILS investment management business in Switzerland, says he believes investors will look at new risks—but only within fairly narrow boundaries.
“It will be limited to a fairly focused area,” he says. “Catastrophe risks are quite easy to understand—if Miami is flattened, investors understand they will lose money.
“When it comes to risks that are more esoteric or harder to understand, they will only get involved if there is good data available and they can see modelled outcomes. I certainly see the market developing and moving into new areas but only within strict parameters and where modelled data can be used.”
This is already happening in some areas. A cat bond recently issued by the Turkish Insurance Catastrophe Pool was very well received by investors, indicating their willingness to move beyond their traditional staple diet of mainstream peak US cat risks.
But other structures are going further, starting with some of the sidecars that are now being used. Lancashire’s first sidecar, launched in 2006, covered offshore energy risks, while its more recent sidecar ventures —Accordion (formed in 2011) and Saltire Re (formed in 2012)—take this strategy further.
“Saltire especially is designed to participate in both cat and non-cat risks, packaging multiple classes of business in one place,” says Redhead. “We will leverage Lancashire’s track record and expertise to do this for third party investors.”
There are other examples of what might come. Michael Sillat, chief executive of WKFC Underwriting Managers and CivicRisk, both owned by the Ryan Specialty Group, says although his specialist area of the excess and surplus lines market has not been affected yet, he has fielded several enquiries.
“Alternative capacity is clearly more prevalent on the reinsurance side and that has not affected the excess and surplus lines market yet. But it could come to us eventually,” he says. “I have talked to private equity investors looking at this market. I am sure when the return on equity looks right they will jump in.”
Schultz agrees that this type of capital will ultimately seek new risks. “There is a preference for cat but over time it is possible we will see this flow into other types of risks too,” he says. “It won’t happen overnight but it is a natural development.
“The key thing investors will seek is good quality data. They will not do it based only on experience as an underwriting tool, as reinsurers do on some risks.
“First, however, I would expect to see a geographical shift in where the capacity is flowing towards cat risks elsewhere in the world. There will be compelling rates to be found outside the peak perils where there is more competition.”
Lohmann reiterates the point that this form of capital will never touch certain risks. “There is a deep pool of capital now and a degree of permanency to that. New risks are possible as long as the collateral is there but this will never touch long-tail risks—no capital markets investors will wait 10 years for losses to develop.
“What may be possible is some form of index-based approach where it is possible to crystallise losses earlier, so that the IRR on a casualty-based transaction is not diluted though the holding of collateral over a long development period.”
Lohmann adds that investors will need to be taught about new risks. “The main thing with moving into new classes would be the education of investors—whatever the risks might be they need to understand them better. That is the nature of the opportunity. Cat is easy to understand. Innovation and education will be needed to move forward.”
The debate does have a flipside, however. The availability of this form of capacity could actually represent a big opportunity for reinsurers, potentially allowing them to combine their skills with this large pool of cash to cover risks that have previously been considered too big and unmanageable for insurers to cover, such as very large energy risks.
Schultz says he believes the onus lies with the reinsurance industry to explore innovative ways of utilising this type of capital. “Innovation could lead to new risks being covered and in new parts of the market. The capacity is there, it is just a question of how creative the industry can be.”
And even if the scope of alternative capacity does continue to expand, there is also a consensus that traditional players will still hold an important role.
Vickers at Willis Re says that few cedants will abandon traditional players completely. “A lot of primary companies have a deep trust with policyholders and need long-term sustainable relationships,” he says. “And a prudent man hedges his bets.”
5. Could banks or investment funds hire reinsurance executives?
Many reinsurers have benefited through the use of structures such as sidecars to combine their expertise with the available capacity. But if the institutions doing the investing hired their own expertise, could reinsurers ultimately find themselves in a talent war with financial markets institutions and potentially then find themselves made redundant in such arrangements?
There have certainly been examples of this with some banks and fund managers hiring actuaries and underwriters. Specialist investment funds, in particular, seem keen on hiring former reinsurance executives.
Schroders, the global asset management firm, for example, recently moved to add ILS to its product offering for institutional clients following its acquisition of 30 percent of the share capital of Secquaero.
As at March 31, 2013, Secquaero advised assets under management of approximately $280 million. And it boasts no other than Lohmann, the former boss of Converium, as its chief executive.
Philippe Lespinard, chief investment officer, fixed income, said: “Secquaero has an experienced team of insurance specialists and a competitive track record and we look forward to welcoming them to Schroders’ fixed income team. Secquaero and Schroders share a common goal to build our presence in this asset class.”
Redhead believes that this is happening in some instances. “Some banks are already doing this: some have hired actuaries and underwriters. The next stage would be for the pension funds to do it.”
Few in the reinsurance industry seem concerned that it could be a big problem. First, some point out that the idea that banks and fund managers pay more than reinsurers is a myth. Others note that banks don’t take risk directly in this way anyway, preferring to form specialist teams around the product.
Vickers agrees. Instead, he sees this as an opportunity for the industry’s talent to shine. “Reinsurers have the global infrastructure, the distribution skills, the underwriting skills and they are getting good at becoming fund managers. If they can harness this capacity themselves, as some are doing, they will prosper,” he says.
In fact, the reverse is occurring in some instances as the industry increasingly seems to be investing in ensuring it has the right talent in place to ensure newly formed relationships with capital markets investors work correctly.
Lancashire Holdings, for example, appointed Redhead on this basis. He had previously served as chief underwriting officer of DE Shaw Re (Bermuda), a hedge fund-backed property catastrophe reinsurer, and as syndicate deputy underwriter of Lloyd’s syndicate Talbot Underwriting, where he was responsible for all reinsurance writing, reinsurance purchasing, and structuring and raising syndicate capital.
Others have also created similarly specialist roles. In Rick Pagnani, Everest Re recruited a seasoned executive with vast ILS and alternative capacity experience to run Mt Logan Re. Pagnani was a partner with TigerRisk and prior to that he was CEO of Bermuda reinsurance startup Ascendant Reinsurance, which focused on catastrophe derivatives.
Before that he was with Quanta Reinsurance and, even earlier, reinsurers including Swiss Re and Zurich Re.
Joseph Taranto, CEO of Everest Re, said: “For Everest, this vehicle adds yet another tool to our underwriting arsenal that allows us to meet the dynamic demands of the reinsurance marketplace and enhance the returns of our investors.”
6. Will we ever see another reinsurance startup?
Given the easy access to insurance risks now available to investors on a short-term basis, could the industry struggle to raise more conventional forms of capital in the future—through traditional share offerings, for example? Certainly, the idea of becoming a long-term shareholder in a startup might look less appealing than it did a few years ago.
Few people expect to see many startup reinsurers emerging in the future. The formation of lots of startup companies on Bermuda used to represent a field-day for executive recruitment specialists, law firms and accountants alike—it also made for colourful journalism and intense negotiations come renewals season. Those days, it seems, are gone.
“We are very unlikely to see many new reinsurers enter the market as we have in the past,” says Lohmann. “The industry has changed in that sense.
Structures such as sidecars represent a far more efficient alternative to take advantage of any spikes in rates the industry might experience in the future.”
In terms of the attraction of investing in already established players, however, it seems such generalisations are not possible. When it comes to the durability of traditional reinsurers, there is no apparent evidence of nervousness among their equity investors at this stage and results throughout the industry remain strong and healthy.
Giorgio Brida, rating agency and regulatory analyst at Willis Re Analytics, makes another interesting point which could reassure many. “People say cat bonds are about to explode but they have been saying that for some time.
If you want to see evidence of faith in the traditional reinsurance model, consider Warren Buffett’s investment in Munich Re recently, which took his stake in the business to more than 10 percent. He is a very good investor and clearly has faith in the traditional reinsurance model.”
Markus Schmutz, head of ILS structuring and origination at Swiss Re, agrees that although innovation will likely mean capital markets investors becoming increasingly involved in different areas of the industry, the traditional model will remain robust.
“We definitely see this as complementary to traditional reinsurance. Reinsurers such as Swiss Re have had relationships with some cedants for nearly 150 years and you will not displace that. Also, reinsurance covers many other types of risk. This will simply remain complementary to the traditional product.”
Meanwhile, Lohmann believes the question is moot. “When you talk about raising capital, what type of capital?” he asks. “This alternative capital is just a capital surrogate anyway. Even reinsurance is just capital relief to some players. This is a tool and depends how they manage that. Is it revolution or evolution? I would say the latter.”
7. Do some sidecars dilute the upside for equity investors?
As reinsurers dabble in this space, could their existing equity investors become disillusioned with the creation of vehicles such as sidecars, seeing them as a mechanism that dilutes their own upside on sometimes lucrative business?
Any company operating a sidecar would deny this is the case. But established reinsurers are increasingly treating this influx of capital as an opportunity by forming their own structures to get involved in the space.
Some are rushing into it and not all companies are doing this in the best way, with reports of confused motives among some of the newer participants and disgruntled equity investors who believe these vehicles have the potential to dilute their own potential earnings.
Redhead says Lancashire Group has consistently used sidecars since it was launched in 2006, and that there are three types of structures used when it comes to sidecars, some of which could well attract the legitimate wrath of a company’s original equity investors.
The first type ends up writing the same type of business the reinsurer would have been covering anyway. “They get a fixed share of an existing portfolio. I think, why bother with that? They should just underwrite that business on their main book,” Redhead says.
The second type is where investors co-invest on certain risks, again effectively competing with the reinsurer for the same business. This structure raises the same problems as the first.
The third structure—the one used by Lancashire—seeks business not covered by the reinsurer’s existing portfolio and invests within certain parameters with the reinsurer taking a smaller level of participation.
But the lure of forming sidecars is also clearly strong. To be seen to be ignoring such a rapidly growing and influential force on the industry can also make a company look ponderous and slow moving.
“It is a dilemma for all established players—should they get involved in this space and, if so, what is the best way to do that?” says Lohmann.
“Certainly, it appears that some sidecars have been formed almost to prove they are at the forefront of the industry and to look innovative. Analysts seem almost to be asking why some companies haven’t gone down this route. It has become a ‘me too’ thing.”
He also notes, however, that where sidecars are used correctly they can be strategically correct and very lucrative for companies. He notes that companies such as RenaissanceRe have been doing this for a long time for very clear reasons and with favourable results.
8. Will insurance business be targeted next?
While the proliferation of ILS and other forms of alternative capacity has had the greatest impact on reinsurers so far, are insurers next in line to find some of their more lucrative catastrophe-related books of business targeted?
On the whole, the influx of capacity has been good for insurers. In fact, insurers are the biggest users of cat bonds, saving money and achieving diversity on their catastrophe-related risk management programmes at the same time.
But some could start to see things differently if they too start losing corporate business as clients start launching their own ILS programmes.
There have been few instances of this so far but in 1999 Tokyo Disneyland issued a cat bond to protect it against earthquake risk, and football’s governing body FIFA issued a bond protecting it against the cancellation of the 2006 World Cup due to terrorism.
Many believe that this could be the next market targeted by cat bond investors. The subject was debated at the annual conference of the UK association for risk and insurance management professionals (Airmic) by a panel that included Stephen Hearn, chairman and CEO of Willis Global, Steve McGill, chairman and CEO of Aon Risk Solutions, and Thomas Hurlimann, CEO of Zurich Global Corporate.
They said that cash from capital market institutions has the potential to bring long-term capacity to the market—the issue will be finding enough opportunities to satisfy demand and this could lead to primary players competing directly with the capital markets.
Hurlimann said that with reinsurers increasingly involving themselves in insurance it was likely that third party capital might begin to express a similar interest.
9. As competition forces cat prices down, will reinsurers recoup margins on other lines?
Will this increased competition for peak catastrophe business ultimately soften rates further in this sector potentially in the long term? And if this does happen, will traditional reinsurers be forced to recoup these margins on other lines of business?
Vickers agrees that there is a real threat that margins on catastrophe business could be reduced in the long term, partly because capital markets investors require a lower return than most reinsurers.
“There is a lot of variation around the world in terms of pricing but on the whole, the capital markets actually require more modest returns. Most reinsurers will be seeking a 15 percent ROE on cat business compared with maybe 8 percent for a pension fund. That is a problem. Reinsurers might have to accept that cat is now a lower margin business than it used to be.”
He acknowledges that could have implications for other lines. “The industry might have to improve rates in other sectors of the market to make up for this,” he says. The flipside of this, of course, is that as traditional reinsurers are forced out of traditional catastrophe lines, there could be more competition than ever for other lines such as casualty business.
In terms of whether the industry can replace this lost business, Vickers says that there are clearly big opportunities. But he also notes that there is no guarantee such growth can be achieved regardless of how much it might make in theory.
“There is a global problem that means cat risks are massively underinsured. But there is a deeper question here as to whether the industry can sell more and whether people will buy it. Governments should be doing more but getting them to pay for it can be tough.”
10. Could growing correlations mean a big catastrophe triggers the next financial crisis?
As the capital markets take ever bigger insurance-related risks, could the next financial crisis be triggered by a catastrophic event? The idea might not be as far-fetched as it seems.
With capital markets investors increasingly involved in catastrophe risks, one concern is that a big catastrophic loss could potentially trigger a crisis in the capital markets—making a mockery of the fact that one of the biggest attractions has always been their lack of correlation with other asset classes.
Brida explored this idea in a blog: Could an earthquake cause the next financial crisis?, in which he sought parallels with a financial crisis that hit the US in 1907.
That crisis, during which share prices plummeted, industry production declined sharply and there was a series of runs on banks, was partly caused by a high demand for gold in the US. In an attempt to stem this outflow, the Bank of England and other European central banks repeatedly raised interest rates and imposed drastic restrictions on the discounting of American finance bills in London, Berlin and Paris.
All this had a dramatic impact on liquidity available to New York banks, thus setting the stage for the panic. But, Brida reveals, the initial demand for gold in the US was caused because it was needed by insurers to pay claims stemming from an earthquake that hit San Francisco in April 1906.
The earthquake caused insured losses of $235 million, close to 1 percent of US GNP in that year. A significant share of these claims was paid by European insurers with a strong presence in California. They had invested part of their reserves in American securities, but were reluctant to liquidate them because they thought the US financial markets were too thin to absorb that volume of sales—hence the decision to pay claims with domestic funds and bank borrowings. Since California policyholders preferred to be paid in gold, this meant actually shipping bullion across the Atlantic, which lowered money supply in the insurers’ home countries.
In fact, Brida says, such a scenario is extremely unlikely in this day and age, mainly because of the sheer size of the global financial markets. “Things are so different now,” he says. “The American financial markets are huge in comparison with even a very big catastrophe event. Even a one in 500 year cat event would be small relative to the size of the capital markets. A very bad earthquake in San Francisco might mean maybe $60 billion in insured losses and $200 billion in economic losses but that is small compared to the financial markets.”
There is, however, a small ‘but’ says Brida. He points out that the real problem in the 1907 crisis was not insured losses but the availability of quality collateral. “With US government debt downgraded and concerns in the eurozone, there is a concern over the availability of risk free assets,” he notes.
“When you consider that it doesn’t look quite so impossible. It is essential insurers have access to liquid high quality investments that they could quickly liquidate if a big cat event happened. If that changed, such a scenario would not be so remote anymore.”
Another scenario that could change things would be if a single insurer or reinsurer were to collapse as a result. Again, he sees this as unlikely but such a scenario could make investors question the validity of the risks they are taking.
Finally, he also notes that there is also the possibility that the world can change in ways we cannot foresee. “Such is the interconnectedness of the world now, there could be scenarios we simply cannot model or foresee,” he says. “That will be the increasing challenge for the industry in the future.”