Could non-traditional reinsurance products now be classed as traditional? asks Steve Breen.

A major shortfall in the availability of catastrophe reinsurance capacity in the US over the last two years has led to greater interest in alternative catastrophe products. These include catastrophe bonds, insurance-linked securities (ILS) and industry loss warranties (ILWs).

If they were termed "non-traditional reinsurance" in the past, it would be difficult to apply the same label now as these capital market products are becoming so common-place. Nevertheless, the accounting for them tends to shift any recovery from the profit and loss side of the balance sheet to the asset side and that does differ from traditional structures. So how should they be described?

Farewell to sidecars

After last year's benign season and a return to capacity in the market, the original sidecars are beginning to be wound up. Those investors just don't see the same rate of return continuing. In the absence of a large US hurricane or earthquake it will be interesting to see how investors look at returns, especially as there will be further downward pressure on rates.

Bucking the trend, some companies, such as RenaissanceRe, have even increased their sidecar capacity, to take advantage of what they think is a thriving market. We are also seeing other Bermudian companies opening new sidecars for peak-zone exposures along with specialty short-tail areas (eg marine and energy). This is a means by which companies can look to diversify into other short-tail areas.

ILWs are an effective way to offload risk quickly, efficiently and without information being passed around the market - a major plus for buyers. As such, ILWs are a thriving market that looks set to keep growing. Cat limits purchased for 2007 are approximately $200bn and ILWs represent approximately 3%-5% of this, giving a range of $6bn-$10bn.

Cat bonds have always been valuable contingent capital - the bond can be shelved and just used when needed. Although cat bonds are not necessarily becoming more sophisticated, they are becoming more "hybrid" and are better able to fit people's books. This makes them very adaptable and user-friendly. Cat bonds have become much bigger than most people could have predicted.

“The rise of alternative capital market solutions is playing an important role in improving industry stability

Renewal pricing

There is a levelling-off of pricing in retro and ILW markets. Currently there are clear reductions compared with this time last year. Capacity is still tight in Florida and the Gulf of Mexico, which has probably kept the pricing in check. Europe has bigger reductions than the US and that's driven by capacity constraints.

ILWs have seen the biggest drop in price since mid-2006 and are becoming even more attractive because of pricing and available limit. Limits are currently stable but are expected to reduce if there is another benign hurricane year in 2007. If this happens, pricing will come under pressure and many funds that have participated may well move away from the sector.

The rise of alternative capital market solutions is playing an important role in improving industry stability. However, the traditional reinsurance market remains the most efficient and the best able to deal with risk. The capital markets are restricted with parametric or modelled output, yet they are becoming more user-friendly. Clearly they are here to stay and the industry must embrace them or lose out.

Steve Breen is executive vice president and president of Carvill New York.