Reinsurers are increasingly competing with their own clients. Dissatisfied with soaring rates in 2006, many cedants are opting for greater risk retention or capital market solutions, discovers Mairi Mallon. So how can reinsurers adapt?

Cedants that are unhappy with reinsurance pricing and terms, particularly in catastrophe-prone areas, are increasingly considering alternatives. This is not only leading to greater use of insurance-linked securities (ILS), but also some of the larger insurance companies are opting to retain more risk.

Those reinsurers and brokers with well-established means of advising clients on using capital markets as well as traditional products will have a head-start when the market booms in the next decade.

Experts agree that capital market products such as catastrophe bonds and sidecars are set to explode, with companies that specialise in this area likely to benefit. Those leading the pack on ILS are giants with specialist teams including Swiss Re, Munich Re and brokers working hand-in-hand with leading bankers in the field such as Goldman Sachs, Lehman Brothers, UBS and Barclays. They aim to provide innovative solutions for their clients.

Getting to grips with the pros and cons of the different ILS solutions is a minefield for clients. Reinsurers or brokers who can offer insurance and reinsurance advice as well as capital market advice for risk, are reaping impressive rewards. The others are scrabbling to catch up, but a shortage in trained teams with the expertise needed to deal in both camps is leading to difficulties in recruiting.

Christopher McGhee, head of Guy Carpenter’s investment banking specialty practice, says: “It is a different expertise for firms like us. You need different licences. You need different kinds of relationships, you need to know who the investors are and have contacts and relationships with them.”

Growing expertise

Over the past ten years, some companies such as Swiss Re have been growing their capital markets expertise. They now have huge divisions that can advise clients on using either reinsurance or capital market solutions to meet their needs. They have also been investing more and more money in this area.

&#8220Experts agree that capital markets products such as catastrophe bonds and sidecars are set to explode, with companies that specialise in this area likely to benefit


According to Jacques Aigrain, chief executive officer of Swiss Re, in 2002 the reinsurance giant used five special purpose vehicles to cover four risks, with the maximum capacity at first issue of $250m. Speaking at a presentation organised by rating agency Standard & Poor’s (S&P), he said that by 2006, Swiss Re had grown 36 special purpose vehicles to cover four risks, with a maximum capacity at first issue of $950m.

Aigrain said that the compounded annual growth rate from 1997 to 2007 was approximately 45%. This translates to a total outstanding amount of $25bn in 2006 compared to $1bn in 1997. In ten years he predicted that growth at the same rate would lead to an outstanding amount of over $1trn, and at a more conservative growth rate of 30%, at just over $350bn.

These dizzying projections have led to suggestions that the industry could see something similar to the transformation that happened in the banking industry in the late 1980s, which saw a low return on equity and volatility trigger dramatic changes.

The increase in the use of ILS was given a seal of approval when rating agencies began to realise investors wanted to measure their performance and give cat bond performance greater transparency. S&P now has cat bond indices, which are maintained and calculated by the agency and updated weekly on Bloomberg.

“I think generally capital market solutions have seen a spike in the last 18 months,” says Peter Grant, an analyst at S&P. “Again, it is not really surprising, as it has tended to ebb and flow in relation to what is happening to capacity in the traditional reinsurance market.”

Previously, he explains, capital market solutions tended to be something that reinsurers pursued for their own risk management purposes, but recently there has been an increase in trend towards primary insurers themselves looking to gain direct access to the capital markets. He pointed to State Farm issuing around $1.3bn in cat bonds, as part of a $4bn programme. “As far as I am aware, [this] is the largest single issuance of the cat bonds,” he says. “Just the spread of the companies looking to gain access to capital market solutions and the quantum of the issuance is increasing.”

From a traditional reinsurer’s perspective it presents opportunities, but it also potentially represents a threat, “The reinsurers themselves are benefiting from their increased access to the capital markets. It obviously affords them a broader range of funding choices and it reduces the counterparty credit risk they used to carry if they wanted to reinsure with other traditional reinsurers.

&#8220In a conceptual sense, the reinsurers’ customer is becoming a competitor of the reinsurer


“So there is an upside there. Particularly for those that are positively geared to capital markets, such as Swiss Re. To some extent they are agnostic as to whether they write the business as a traditional reinsurer or advise a primary writer in placing its risk in capital markets.

“It is probably less of a threat to them, because they have that broad-based product offering, than it could be to the more traditional players who haven’t yet really built out their capital market expertise.”

Many reinsurers are currently increasing that expertise. Mark Hvidsten, chief executive officer of Willis Capital Markets, said the broker has been building up their team for a number of years with offices in London and New York, and have 14 people dedicated to this area. “I think there are massive opportunities for different constituencies in the game,” he said. “The opportunity for insurers is that they have more than just the reinsurance market to look to to finance the risk they are assuming.

“The opportunity for reinsurers is to be more discerning about the products they sell to their customers and to leverage capital-intensive exposures more precisely. And the opportunity for people like us [brokers] is to help clients, whether they are insurers or reinsurers, navigate this difficult terrain and provide them with solutions that are outside of the traditional way of doing things, ie capital markets.”

Munich Re, the world’s second largest reinsurer after Swiss Re, has also been building up its expertise, and has the size to be able to offer a wide range of products. Torsten Jeworrek, head of reinsurance at Munich Re, said the company wants to create new fields of business and markets, which would go beyond the boundaries of traditional reinsurance. “We expect the capital markets to play an important role with new chances to firstly, better manage our own risk, secondly, to structure the risks of our clients and thirdly to act as an investor,” he explains.

Intermediaries of risk

Many insurance companies are looking at all forms of capital, and evaluating the efficiencies in each, rather than just buying traditional indemnity protection, believes Mike Bungert, president and chief executive officer of Aon Re Global-Americas. “We help our clients look at multiple options from traditional reinsurance, alternative reinsurance and capital markets solutions,” he says. “We also help clients understand credit risk and measure the viability of collection in some multiple loss scenarios.” Bungert believes a combination of traditional reinsurance and capital market strategies is the way forward and will be necessary to protect against future volatility.

&#8220Are reinsurers worried? Sure they are. It will probably take a market-changing event or the market softening to gain momentum for this situation to change


So how do reinsurers feel about these developments? McGhee says he does not think they are all that worried by the changes as they are heavy users of capital market solutions and were actively participating in this marketplace already. “Our general hope is that the availability of the capital markets will actually increase the pie, not re-cut the pie,” he explains. “[Reinsurers] stand to assist clients by taking the risk and repackaging it. Currently we see that is already happening, that reinsurers are acting as intermediaries of risk, rather than simply just holding the risk themselves.”

Retaining risk

Cedants also continue to retain more risk themselves and this is due to stronger balance sheets and what are considered to be restrictive terms and condition, says Bob de Rose, an analyst at AM Best. “It is pretty consistent across the board, both large and smaller companies. If they can, they are buying less reinsurance. Some of the larger players are going to the capital markets.

“Are reinsurers worried? Sure they are. It will probably take a market-changing event or the market softening to gain momentum for this situation to change. Some may use arbitrage to get a better deal, but so far reinsurers are trying to remain disciplined, which is a positive for the reinsurance business. It is better to write less business at a profit than to write more business at a loss.”

Grant agrees that cedants are keeping on more risk as a result of stronger balance sheets than was the case five years ago. “Certainly a theme at the January [2007] renewals from the reinsurers’ perspective was that generally speaking a lot of their cedants were opting to retain more risk,” he says. “Part of it is they feel pricing for certain cat-exposed risk is not economic for them to purchase. It is a market, like any other, and I guess it is about finding the equilibrium price that brings supply and demand back into line. A lot of the big primary writers say the price is just too high.”

Hvidsten says there is nothing new per-se about insurers retaining more risk. What is happening for the first time, he explains, is reinsurers with high capital charges have to cut back or cannot take any more. “So when their traditional customers, like State Farm, say, ‘We do actually want some reinsurance now’, reinsurers are not in a position to provide it. So their customers have to go either into the capital markets or find a way of retaining the risk themselves more efficiently than just sticking it on their balance sheet. Now, in a conceptual sense, the reinsurers’ customer is becoming a competitor of the reinsurer.”

Hvidsten adds that when it comes to more diversified types of risk or less capital-intensive types of risk, reinsurers still have plenty of capability to sell their product. “Capital markets are not a real kind of threat in that area.”

Mairi Mallon is a freelance journalist.