Has retrocession disappeared without a trace as it did after Hurricane Katrina? Global Reinsurance goes on the hunt for retro capacity in the post-credit crunch environment.
Retrocession – reinsurance for reinsurance companies – has all but disappeared according to the reinsurance renewal reports. Non-US retro pricing was up 5%-10% and US pricing was up 10%-25% at the 1 January renewals, according to Aon Benfield. While capacity was available for those seeking renewals, new programmes struggled to secure desired limit, revealed the broker.
“Virtually all of the players involved in the retro market have withdrawn,” says Julian James, chief executive officer of Lockton International. “I think it’s going to be one of the factors that is going to help drive up reinsurance costs. From a buyer’s perspective it’s a tool that’s been taken away from their reinsurance armoury. Therefore there’s going to be less choice, and less choice tends to result in the higher cost of buying reinsurance programmes.”
Retrocession hasn’t disappeared, insists Bryan Bumsted, vice president and retrocession underwriter at Lancashire Insurance Company. Capacity is relatively flat at present, but demand has increased substantially. “The biggest difference between the retro market now and the retro market last year is not capacity, it’s the saturation of that capacity,” he says. Even the new retrocession players that entered the market in 2008 have none to spare. “Last year we had DE Shaw and Aeolus coming into the market in a big way and this year, post loss, they’ve filled their boots with accounts they want to write.”
So why has demand risen so sharply? It’s partly linked to catastrophe losses in 2008, in particular claims from hurricane Ike. While ISO’s Property Claim Services (PCS) still ranks Ike as a $10.7bn loss, Risk Management Solutions has warned losses could reach $20bn. A number of reinsurers have revised their Ike exposures upwards – including IPC Re, Advent and Validus – and collateralised vehicles such as ILWs and cat bonds could yet be triggered should PCS up its estimate.
But Ike was not another Katrina, insists Bumsted.
Unlike Hurricane Katrina in 2005, which burst through all the top reinsurance layers and exhausted most of the retro programmes, Ike has only affected around a quarter of the retro limits purchased. “That’s not a major loss. The majority of retrocessionaires actually made money,” he says. “It’s not something to brag about, but such was the case last year.”
This is proof the post-Katrina adjustment in retrocession pricing was adequate, says Bumsted. He thinks the retro industry would comfortably absorb another Ike-sized loss this year, should it happen.
“Ike offered us a good benchmark to see if the relatively newly updated cat modelling was accurate – if we’d attached and exhausted in the right areas.”
Of course, 2008 hit reinsurers on both sides of the balance sheet. As is now becoming apparent in the fourth quarter results, many players suffered significant investment writedowns as a result of the ongoing financial crisis. The lack of liquidity has driven up the cost of capital. For many carriers, this makes purchasing reinsurance and retrocession a cheaper alternative than raising capital elsewhere.
With demand for retrocession rising, the withdrawal of CIG Re and Lehman Re has exacerbated the situation. Just as hedge funds poured money into the industry in the hard market after Hurricane Katrina, now they are pulling out again. On 7 November 2008, hedge fund Citadel announced it was closing its Bermuda-based collateralised reinsurer CIG Re because the cost of capital had got too high.
A favourite for hedge funds has been industry loss warranties (ILWs). Contracts generally last just a year and have easily-understood parametric or industry loss payout triggers. Demand for ILWs grew at the 1 January renewals, but supply has not kept up. These reinsurance or derivative products have seen prices soar as a result.
“We’re seeing how fast the hedge funds leave – you saw Citadel Re,” says reinsurance consultant Andy Barile. “They just close up, they sell the renewals to somebody, everybody looks for another job and it’s over. That’s the way the hedge funds think. All of a sudden the big splash that Citadel Re made in the market is all over.”
For the time being, collateralised retrocession protection from cat bonds, sidecars and industry loss warranties is not helping to plug the gap as it did after Hurricane Katrina. “The biggest concern at the moment is the duration of the recession,” says Bumsted, “and how long that translates into available capital being brought into these unrated markets that have been bolstering the retro market as a whole for the past year.”
NO CLASS OF 2009
In the months after Hurricane Katrina over $30bn of fresh capital flowed into the industry – much of it into Bermuda. Some investors funded new reinsurance start-ups while others invested in insurance-linked securities and sidecars. In the present environment, such replenishment is unlikely.
The capital crunch won’t last forever though, says James. “You’ve got to differentiate between the long term and the short term. That capacity will come back, but in a world where banks are not spending money and people do not want to get involved in areas of risk that they don’t understand, it’s not surprising that that market is drying up.”
Should capital return to the industry it is more likely to flow into sidecars than new reinsurers, believes Barile “because it’s an easy way to get in and out and it’s inexpensive.” But the economic environment and high number of corporate collapses has made cedants more wary of unrated capacity. Even fully-collateralised capacity is not deemed as failsafe as it once was as a result of the Lehman linked cat bonds.
Lockton’s James questions if the ILS sector will return to its post-Katrina glory: “Ever since the Rendez-Vous de Septembre last year I’ve been saying that the market that is going to be most responsive to buyers’ needs is the traditional reinsurance market.”
He thinks cat bonds and securitisation vehicles are going to be “less important” as time goes on.
The growing insistence on rated capacity could provide an opportunity for new retro providers, assuming it is possible to raise the start-up capital. “Based on expected returns and the fact that capacity is scarce when compared to demand, I would definitely see retro as an enticing prospect for someone looking to enter the insurance or reinsurance space,” says Bumsted. He thinks the ever-shrinking sector would benefit from the arrival of one or two new players.
The market has become more transparent over the past five years, but retrocession remains a small and somewhat secretive universe. “You’ve got a very tiny subset that looks to purchase coverage in the form of retrocession – so it adds to the mystique,” says Bumsted. “But it’s not quite as opaque as it seems – it’s just a little bit less common and so it’s discussed a little bit less.”