Aspen Capital Market’s Brian Tobben takes a fresh look
The influx of reinsurance capital from non-traditional sources has escalated in 2013, and with estimates of around $45bn, it now accounts for some 15% of the property catastrophe market, writes Aspen Capital Markets managing director Brian Tobben.
In terms of products, collateralised reinsurance and catastrophe bonds are roughly equal in size. Sidecars, once principally in the domain of the hard market, have re-emerged.
Low interest rates have played a part in the market’s growth as asset managers have had to search further afield to find attractive returns. Yield has, however, been only part of the story with the benefit of diversification providing the stronger attraction. Unlike most asset classes, catastrophe reinsurance returns are not economically driven. This, coupled with the relative outperformance of the insurance linked securities (ILS) asset class through the credit crisis, has led to the recent surge in investor interest in catastrophe risks. While it would not be surprising to see temporary declines in investor interest in catastrophe, the overall long-term trend is toward further growth in third-party capital.
Initially, alternative capital focused on hard market opportunities through sidecars. During the post-Katrina, Rita and Wilma hard market, hedge funds and private equity funds dominated the investor slate. The market has now matured and is characterised by a different type of investor with a more persistent appetite and a lower return target – namely the pension funds, endowment funds and mutual funds looking to invest in catastrophe risk.
Alternative capital highlights a key factor in the pricing equation – namely concentration of risk. US wind is a peak zone in the context of the traditional reinsurance market and as such commands peak market pricing. But US wind exposures are not a peak exposure for the broader investment market. The global catastrophe risk market is roughly equivalent to 1% of global pension fund assets. Since catastrophe is not economically sensitive and is not a peak exposure, third-party investors can accept lower returns than the catastrophe market has recently produced.
Contrary to some opinions, this new capital is not pricing catastrophe risks irresponsibly, but simply reflecting their lower cost of capital for a diversifying risk. Another way to think about this is capital impairment post event. A large catastrophe event will be a greater loss as a percentage of assets for the reinsurance industry than it will be for the pension fund industry.
New capital markets structures and the growth of the catastrophe fund industry have streamlined access into the property market for third party capital. This has shortened and muted the catastrophe pricing cycle. The way in which traditional reinsurers face up to this competition may vary, but standing still is not an option. By embracing alternative capital, reinsurers can leverage their underwriting franchise and enhance operational flexibility. Convergence offers three main opportunities for the traditional reinsurer. First, the cost of reinsurer capital for peak zones can be lowered by managing risk through the ILS market. Second, sidecars can strengthen the relationships with key clients through larger line sizes. Finally, through an asset management model, reinsurers will generate fee income by leveraging their risk management expertise.
Historically, third-party models have played a central role in the development of alternative capital appetite for catastrophe risks. As the convergence markets expand from personal lines catastrophe risks to more complex commercial and specialty exposures, underwriting expertise will be essential. Reinsurers are well positioned to leverage their modelling, underwriting and research capabilities into value added asset management services. While asset management fee income may provide a vital new source of revenue, underwriting excellence will remain a key factor in the long-term prospects of any reinsurer.
Importantly, the client stands to benefit most from these new market dynamics. Capital efficiencies coupled with the expertise and experience of a reinsurer in managing risk will result in new products better suited to meet cedants’ needs. A combination of the strengths of traditional reinsurance and the lower cost of alternative capital is the right way to go for the customer – there is a need for both.
By Aspen Capital Markets managing director Brian Tobben.