Is the boom in capital market products coming to an end? With the industry anticipating record profits for 2006, Ronald Gift Mullins considers what impact this could have on the appetite of capital market investors.

Even before 2006 had ended, record profits were being proclaimed for the insurance and reinsurance industries. In addition, close to $5.4bn in catastrophe bonds came into the market last year, almost double the $2.4bn of 2005, along with $3.8bn for sidecars, up from $2.3bn in 2005, according to Goldman Sachs. With this bright assurance of abundant surplus, expectations were that the January reinsurance renewals would bring lower rates as the age-old reinsurance cycle began its inevitable rotation fuelled by too much capital chasing too little risk, resulting in a competitive rush to write more business at lower rates if necessary. And as rates fell for traditional insurance and reinsurance, the expectation was that interest in alternative risk transfer (ART) products would ebb as well.

Rates, however, did not collapse pell-mell. In a report on the January renewals, Willis said that rates for both property and casualty exposures were generally flat or fell modestly. It said that wind-exposed Northern European multi-territory risk remained firm, but rates for all other areas of the world, except for US property business prone to natural catastrophes, remained unchanged or lower by 5% to 10%.

Orderly renewals

In its January renewals report, Benfield said the reinsurance market had seen "orderly" renewals at the start of 2007. Reinsurance capacity at the end of 2006 was "more than adequate", even for peak exposures, the report continued, with a continuing squeeze on the retrocession market as the only constraint. Low catastrophe losses drove strong earnings and billions in new capital came into the market.

Despite some signs of competition returning to many lines, Benfield noted underwriting discipline "generally prevailed" at the January renewals. The constraints imposed by recalibrated catastrophe models and more stringent rating agency capital requirements mandated that reinsurers had to review and rewrite many of their policies by being more prudent to prevent excessive aggregating of exposures.

"In 2006, we saw a gradual easing of traditional reinsurance capacity and a further development of capital market alternatives," said Benfield CEO Grahame Chilton. The growing influence of alternative capital is one of several key market issues analysed in the report. It concluded that the increasing ease with which capital market vehicles (such as sidecars and catastrophe bonds) can participate in the reinsurance market may have longer-term implications for the reinsurance cycle. "While these (ART products) are still a small percentage of global reinsurance capital," the report continued, "the pace of innovation in this area suggests that alternative solutions will continue to develop alongside conventional reinsurance."

A powerful deterrent to reinsurers' lowering rates has been the lack of retrocession capacity for reinsurers to off-load their catastrophe risks. Consequently reinsurers have had to retain more of their catastrophe exposure, which compels them to keep rates high enough to produce adequate returns for shareholders as well as to add to retained earnings.

Although traditional reinsurance and retrocession entities hold most of the capacity, the billions poured into the ART market within the past two years has been impressive. According to Moody's, existing and startup reinsurers have raised approximately $19bn in capital since 2005, and sidecars and catastrophe bonds account for more than $8bn. Indeed, interest in the ART market, contrary to past trends associated with the insurance cycle, has not ebbed but has swollen in volume, importance and variety.

Captives still growing

Twenty years ago about the only ART product, besides self-retention, was a captive, usually formed in Bermuda. Now, the range of ART products encompasses cat bonds, securitisation, sidecars, industry loss warranties (ILWs), loss prevention programmes and loss control measures, risk retention groups, higher self-retentions and deductibles. And like an all-seeing, encompassing umbrella, enterprise risk management is now increasingly used to determine how much risk a company can afford to take on overall, and how much to insure or transfer to reinsurers or an ART mechanism.

During the early stages of the hard market last year, many new captives were formed - not only in Bermuda and other countries, but also in various states in the US. "We are still seeing a steady flow of new formations of captives," said Tim DeSett, senior vice president of risk management at Lockton. "There are new captives in healthcare, extended product warranty, home builders' defects. These companies are having a tough time finding a place to park their potential liability. For example, there is a whole new trend in healthcare. More and more smaller hospitals are consolidating with each other. Before as a separate entity, it may not have had the resources to form a captive, but now by being part of a much bigger hospital group, it does. Doctors are also going into captives. Captives are far from an outdated mode of the alternative risk market."

Mark Jablonowski, senior research analyst at Conning Research & Consulting, observed that while insurance continues to be a very efficient risk treatment option, alternatives do exist. "Risk managers carefully weigh up the costs and benefits of each alternative when structuring optimal risk financing programmes," he said. While they may not be as trendy as cat bonds or securitisations, he noted, the majority of the alternative market today consists primarily of self-insured retentions, often supported by captives. "Retention alternatives are near or at their peak for individual companies that already utilise extensive self-retention,' he said. "Risk managers are recognising that retaining too much risk is not good, that insurance has value. At the same time, a new wave of alternatives are emerging and focusing on capacity rather than price and competing more directly with traditional insurance and reinsurance."

Fresh capital sources

One reason demand for catastrophe bonds has exploded, according to Warren Isom, senior vice president at Willis Re, is down to the volatility produced by greater risk retention. According to Isom, "The more risk they retain, the more their earnings may be subject to greater volatility from large losses. Insureds are looking at structured alternative risk programmes which can be set up to manage the increased volatility in earnings due to the increased retention of risk."

Paul Schultz, president of Aon Capital Markets, broadly views the security market as a complement to the traditional insurance and reinsurance markets. "I do think that securitisation will continue in addition to sidecars," he says. "We will from time to time see new types of alternative products. Up until now, it has been on a property basis, but clearly there can be liability bonds. The market will continue to develop."

Creating a catastrophe bond or a securitisation can be costly, difficult to put together and require close administration, reminds DeSett. "I think there will still be interest in sidecars," he said, "but it will be a declining interest in 2007 because the traditional marketplace will provide more acceptable coverage at less cost and clients will return to the easier means of transferring risk, which is insurance. Insurance is a very efficient mechanism to transfer risk which makes the alternative risk programme a little less positive." This is because there is greater certainty with an insurance policy, he explained. It can be completed in about 30 days compared to 90 or more days to lock in a cat bond.

There are two areas where hedge funds participate in reinsurance and insurance, according to Isom. "They support cat bonds, ILWs, privately placed notes, and other instruments," he said. "They also invest in sidecars, which is a means for outside capital to invest in traditional insurers or reinsurers without actually forming an independent insurance company. But in all cases, the contract exists for a fixed term. The insurance business has had cycles for years. Profits attract more capital and companies start writing more business, the market softens, and then the cycle starts over again. The past has suggested that when money comes in because of high returns, there is usually enough risk to fill its place. So if hedge funds leave, capital will surface from the usual sources." Isom believes hedge funds and other forms of investor capital will remain as long as acceptable returns are maintained.

Hedge funds for how long?

According to Chilton, the capital that flooded into products such as sidecars, catastrophe bonds and ILWs in 2006 was opportunistic, and will remain that way. "The capital that's coming into these new capital markets products has a choice - it's not its main business, it's on a profit-hunter mentality," he explains. "And if it can't see a profit then it will withdraw the capacity." With capital market capacity moving into and out of the market in this way, Chilton believes it could have an important role in smoothing out the reinsurance cycle. "Instead of having enormous peaks and troughs they should have a more gentle oscillation to them."

Maharai Mahindra, senior vice president, Willis Re, notes it is tough to know what will happen to capital outside the insurance industry. "If treasury rates go up a great deal over the next year or so," he said, "capital that entered the insurance and reinsurance market may leave even if there are no catastrophes. Treasury bonds are just more stable and payouts are known."

Another source of capital outside the private sector, according to Jablonowski, is available through the many government pools and programmes, such as the Terrorism Risk Insurance Act, windstorm pools, national flood insurance programmes, crop/hail insurance, Federal Emergency Management Agency and others. These cover risks that are low frequency but high-end capacity, such as losses from nuclear accidents and terrorist acts. These are part of the alternative market, yet not connected to commercial insurance or to the capital markets.

Certainly the world of risk will become more complex and costly as time goes by. The management of insurance and reinsurance companies will continue to create innovative structures to cover these risks. And the movers and shakers of the ART industry will continue to create products to complement traditional insurance and reinsurance products. Schultz believes there will come a time when certain ART products may be more prevalent than traditional ones, such as securitisation, "which is an almost inexhaustible source of capital."

The overall consensus is that there's no immediate end in sight to the appetite of capital market investors. "I think the alternative market is growing," says Isom, "and will continue to grow in 2007. But the market will shift as it responds to changes in the insurance and reinsurance markets, and as insurers and reinsures rub elbows with the financial markets."

- Ronald Gift Mullins is an insurance journalist based in New York City.