Is the reinsurance industry now overcapitalised? With prices now falling for many lines of business Christopher Kershaw and Andrew Poulton explain why there is too much capital in the market and what the consequences might be.
Despite dire expectations and forecasts, 2006 has turned out to be very different from 2005. The noises about needing to manage the cycle made early in 2006 have grown louder - the current assumption is that too much capital has been piled into the reinsurance market and unless it can be put to good use some of it must now be returned to shareholders. One might surmise that as a market we do not trust ourselves to use surplus capital wisely, so we had better give it back. In the light of previous cycles, perhaps we should heed this advice. However, the temptation to deploy surplus capital by considering mergers and acquisitions should not be underestimated.
The evidence supporting the assumption that there is too much capital is that prices on many lines of business are under pressure if not already falling. In addition, adequate capacity exists for almost everything except US catastrophe-exposed business, certain markets remained flat after 2005, when they were widely expected to harden, and there is adequate capacity for offshore energy business in the Gulf of Mexico (now that a lot less reinsurance is bought).
Some numbers support this assumption too. Lloyd's of London has announced a record level of capacity for 2007 (£16.1bn) and taken great pains to explain that its capacity would only be used for profitable underwriting, pre-empting any speculations to the contrary. And Bermuda continued to attract new capital into the industry during 2006, having raised $8bn in the immediate aftermath of Katrina.
Exception to the rule
Yet, how can there be too much capital in the reinsurance market when there is still a shortage of capacity for catastrophe risks in the US? Surely, this is the benchmark sector for reinsurance given its size, and until it finds adequate amounts of cover for its catastrophe risks the market cannot be said to be overcapitalised.
This sector is lacking in capacity despite the fact the majority of new capital attracted into the reinsurance market since 2001 has entered the market looking for the potentially high returns this sector can offer. The dominant position of the US in absorbing reinsurance capital, or the ability to write catastrophe-exposed business on the back of that capital, is not likely to change in the near future. Rating agencies seem unlikely to adjust their models to a point where less capital is required to support a given level of catastrophe underwriting. Indeed, this issue is partially responsible for the current situation.
Insufficient capacity for US catastrophe-exposed business has tempted a number of non-traditional entrants offering derivative products such as catastrophe bonds, collateralised risk vehicles and industry loss warranties (ILWs). When it comes to losses, these products offer a greater degree of certainty to capital providers through a clear definition of what must happen for a payment to be triggered, and therefore they could be seen as a way for the market to bring supply and demand in this sector back to a position of equilibrium.
However, even if equilibrium in the US catastrophe sector can be restored through the efforts of non-traditional capital providers (a point likely to be disputed by many market practitioners), it is unlikely to affect pricing in other sectors. But what about pricing equilibrium on a global scale? Are we seeing the development of two separate reinsurance markets?
Tale of two markets
Perhaps we should review the original assumption of excess capital in some market sectors and a shortage of capital in others. Using relative prices and price movements can be misleading as portfolios are balanced differently in different sectors. The geographical position from which the issue is viewed is very important in determining the attitude to the issue. The high risk, high return US sector tends to dominate thinking in the London and Bermuda markets, and from this point of view, international business may seem very competitively rated. However, when viewed from the position of regional players in Asia and the Middle East, the competitive pricing of this business would appear very different and appropriate for the actual level of risk.
Equally, those regional specialists may see US business as volatile and unattractive. The capital requirements for the regional players are substantially lower, and they are prepared to take significantly less risk of catastrophe and other shock losses. They do not need to achieve the rating levels required to attract the capital supporting US catastrophe-exposed business, as the quantum of cover demanded across their regions is more easily satisfied. In many instances, they operate from centres with lower costs compared to London or Bermuda, and therefore approach business on a different basis. The value proposition offered by the regional players to their clients is tested regularly, and the margins on which they are expected to operate are significantly lower than in London or Bermuda.
In many ways, inherent checks and balances inhibit capital movements from one camp to the other. Players in the high risk, high return sectors such as US catastrophe or offshore energy in the Gulf of Mexico would struggle to operate efficiently in the lower premium per acceptance environment that the regional players inhabit. Equally, a lack of financial scale tends to prevent the regional players from being tempted into the high risk, high return sectors. The danger comes when the capital providers that feed off the high risk, high return sectors look to expand into international markets without the in-depth knowledge that comes with direct experience of the environment. Ventures undertaken on this basis are more akin to adventures, often with disastrous consequences that befall the ill-prepared.
And what about the big global reinsurers? They operate across the entire market spectrum, and the divergence of risk pricing would affect their global strategies. How can they achieve a consistent underwriting philosophy given the existence of two separate markets with disparate fortunes? The answer is that although the global reinsurers look to understand and participate in international markets, they no longer look to write the entire market but rather select their portfolio of clients within this market. They participate in technical lines on a global basis, and so have a consistency of approach on lines such as offshore energy or aviation that aligns with other market participants. One important difference is that they are far closer to the original insurance markets than pure catastrophe providers and have probably taken the most significant capital management steps in looking to use event limits in proportional reinsurance treaties to manage their own catastrophe exposures more effectively and at lower cost.
Impact of global equilibrium
So does this lack of global equilibrium pose a serious threat to the industry? Arguably, it shouldn't. A well-capitalised reinsurance market would attract a wide range of clients. It is not sustainable to only build the reinsurance industry on the basis of attracting cedants who do not have another option.
The collective ability of the reinsurance market to adapt to meet new challenges suggests that in time those who currently stand on the sidelines of emerging and developing markets will find a way to engage. They have just not done so yet. At the same time, those same developing markets will continue to evolve and expand. Economic development will aid insurance penetration, and where the economies need assistance to grow and develop, the entry routes for reinsurers may be through non-traditional agencies, established as a result of initiatives undertaken by the World Bank, the Asian Development Bank or similar organisations.
A final point regarding capital and the imbalances in its allocation is effective regulation. Regulators around the world need to address structural problems that might exist in their local insurance markets to aid the "invisible hand" of the reinsurance market. An industry that is effectively regulated would offer an environment where capital providers can expect to achieve stable returns over time, even in catastrophe-exposed areas. Consumers and shareholders' interests need to be protected - in some cases this may mean greater regulation while in others it may mean less but more effective regulation. The industry as a whole needs to engage with regulators to make insurance relevant, sustainable and affordable, so that reinsurance remains able to manage the real peaks and challenges that are likely to come our way with increasing frequency.
- Christopher Kershaw is partner with JLT Re Asia, based in Hong Kong and Andrew Poulton is head of JLT Re's business research practice in London.