Abundant capacity from traditional and alternative sources creating “new reality” for reinsurance market: A.M. Best

The reinsurance market is operating in a “new reality” of abundant capacity from traditional and alternative sources, low interest rates and thinner reinsurance margins driven by intense competition against shrinking demand for reinsurance cover, ratings firm A.M. Best Company said in a special report released on Wednesday.

The Best’s Special Report, titled It is Not Your Father’s Reinsurance Market Anymore – The New Reality, noted that alternative sources of capacity began to enter the market, attracted by the increased reliability of risk models, diversification benefits and potential returns to investors. “The low-yield environment that has been in place since the 2008 financial crisis made these types of investments all the more compelling for investors,” the report said.

More recently, investors and users of alternative capacity, largely provided by pension plans, sovereign wealth funds and hedge funds, “are bypassing the traditional reinsurer and transferring risk directly to the capital markets,” the report explained. Lower interest rates have led to an increased inflow of alternative capital as investors look for uncorrelated ways to improve returns. “This phenomenon has given rise to collateralized funds, unrated sidecars, more flexible forms of ILS (insurance-linked securities) and the birth of ‘Hedge Fund Re,” looking to optimize investment returns offshore while building a base of long-term assets under management.”

According to Guy Carpenter, today’s alternative capital accounts for about 18% of total dedicated capital in the global reinsurance market, compared with only 8% in 2008.

And with current market conditions of double digit price declines, increasing commissions, lower premiums and increasing competition, the need for mergers and acquisitions is becoming clearer and “A.M. Best believes that consolidation will continue, particularly among smaller players in the market as acceptable returns become increasingly harder to achieve.”

A.M. Best added that the “new reality” for the reinsurance market “looks to be more of an industry where returns are less impressive and underwriting will have to become a larger contributor to profits and returns, leading to more conservative risk selection, more diversification of product offerings, a wider geographic reach and less conservative loss picks. The solid players will be the ones that have been conservative in underwriting and in reserving, have been able to develop a book of business that will remain relevant for today’s market and that allows for quick shifts in and out of lines of business depending on market conditions, as well as companies that have created expertise in managing third-party capital to their own advantage.”

In conclusion, “the winners will be able to walk away from bad business; will have the capital and expertise to write new, more complex lines of business; will provide the products and services clients want in a global economy; will be able to manage the inflow of third-party capital to their own benefit; and will be able to participate in the new era of consolidation without being left out of the game.”

Given the significant, ongoing market changes that “will hinder the potential for positive rating actions over time and may translate into negative rating pressures,” A.M. Best is holding its outlook for the reinsurance sector at negative. “Declining rates, broader terms and conditions, unsustainable flow of net favourable loss reserve development, low investment yields and continued pressure from convergence capital are all negative factors that will adversely impact risk-adjusted returns over the longer term,” the report said.

In addition, the convergence market is “here to stay” and will continue to play an important role in the risk transfer and risk mitigation process for both p&c and life/health catastrophe exposures, which could help dampen the pricing volatility observed in the reinsurance and retro markets.

The report also noted that the abundance of reinsurance capacity challenges the competitive position of Lloyd’s. While the abundance of traditional/alternative capacity is creating difficult trading conditions in the core markets of Lloyd’s, the market has responded proactively to these threats. Consolidation of broker panels and growth of pre-brokered facilities are putting pressure on Lloyd’s participants, particularly smaller managing agents without a niche offering, the report said. “Meanwhile, the growth of regional (re)insurance hubs, combined with the comparatively high cost of placing business at Lloyd’s, is reducing the flow of business into the London market.”

The report noted that total reinsurance premiums fell 5% in 2014 to 8.5 billion pounds, largely as a result of softening property and marine premium rates in the absence of major catastrophe losses.