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The new capital paradigm

Source: Asia Insurance Review | Sep 2018

The insurance industry is facing disruption from multiple angles. Low interest rates are depressing investment income, rapidly evolving technologies are redefining business strategies, and abundant capital is keeping rates low. In this context, both insurers and reinsurers are taking a careful look at their balance sheets in an effort to unlock value and increase return on capital. Guy Carpenter & Company’s David Priebe explains the background.
For insurers and reinsurers, a comprehensive review of the balance sheet involves a portfolio review to increase risk understanding and properly allocate resources to the most profitable lines of business. It also means a review of all solvency regimes in which a company operates to ensure the required regulatory capital is likely to generate acceptable levels of profit. In response, both are leveraging advanced analytics and catastrophe models to match the most efficient capital with emerging risks, creating capital-efficient structures that use contingency capital rather than equity capital to support the customisable solutions today’s clients demand and improve operational flexibility to capitalise on new opportunities.
During the global financial crisis of 2008, collateralised insurance risk represented one of the few asset classes to hold its value. Investors quickly recognised the diversification benefit of including this non-correlating risk in their portfolios to reduce volatility and improve overall returns. As such, we have seen an exponential increase in assets under management directed at insurance risk, with the asset class growing from $20bn in 2008 to well over $90bn today. This broadened interest from investors has created new opportunities for insurers and reinsurers to improve capital efficiency. 
As a result of this increased access to new forms of capital, innovative companies began developing more flexible capital structures that allowed for the introduction of more complex, customised covers designed to meet the specific needs of individual clients. These carriers were able to differentiate, finance new product offerings and drive profitable growth. Coverages became broader and more flexible as reinsurers began offering special features for specific industries or risks unique to specific clients or partnering with their insurance company counterparts to support new primary products. 
New structures
Today, this shifting capital paradigm is becoming entrenched in capital-efficient corporate structures that depend less on equity or debt issuance to finance operations and more on capital markets and reinsurance, leveraging the balance sheet to facilitate this transition from traditional, commoditised risk products to more tailored capital advisory solutions. 
Attracted by the favourable yield and non-correlating nature of insurance-linked security (ILS) products, capital markets investors continue to flock to the sector. Perhaps an even more important factor in this trend was the ILS markets’ response to the loss events of 2017. Despite being only the third year on record with losses over $100bn, convergence capital, which includes collateralised reinsurance, sidecars and catastrophe bonds, paid losses as expected. Lost capacity was also quickly restored and pricing remained competitive, demonstrating investors’ commitment to the asset class and proving its reliability to corporates, governments, and (re)insurers around the world. 
Record issuance
As a result, the first six months of 2018 has already seen record levels of catastrophe bond issuance and capital outstanding, with $6.76bn issued year to date, according to our estimates. For comparison, the total issuance in 2017 was $10.25bn (see figure 1).
P&C catastrophe bonds issuance and capital outstanding 1998-2018YTD
Convergence capital overall represented roughly 22% of global catastrophe capacity at year end – a figure we expect to continue increasing in 2018. In fact, Artemis estimates that total ILS and reinsurance-linked assets have already grown 23% this year. Much of this comes from independent ILS managers, with pension funds and sovereign wealth funds increasing their participation in the space. 
Sidecars and alternative capital facilities in particular are becoming an important form of contingency capital for (re)insurers. These solutions can serve as valuable capital tools compared to some other securitised products by giving a company greater control of risk transfer terms and conditions, but maintaining alignment with capital market investors through greater access to underwriting practices, client relationships and distribution networks. 
Examples of the success of such solutions include two recent efforts by Brit, and Liberty Mutual’s Limestone Re. In December 2017, Brit launched a new collateralised vehicle Sussex Re, followed closely by the fourth expansion of its Versutus platform to $187m in February, augmenting its own risk capacity with the two fully collateralised solutions. And Liberty recently made its second issuance under Limestone Re, securing $278m of protection despite its first issuance facing possible losses from the 2017 natural catastrophe events. 
Smart investors
Innovative (re)insurers are also increasing their use of legacy portfolio transfers and structured solutions, such as loss portfolio transfers and adverse development covers, to move capital-consuming business off their balance sheet and free up capacity for more strategic opportunities. This allows carriers to redeploy the large amount of regulatory capital required under Solvency II and other new capital regimes to fund such business. These companies can then react more swiftly and nimbly to new market developments and dedicate capacity to developing new, tailored solutions to address the emerging risks of each individual client. 
This capital management strategy has been leveraged by several leading insurers in recent years. In 2017, AIG transferred much of its US commercial long-tail liability for accident years 2015 and prior to Berkshire Hathaway. Many of these policies had already incurred higher than expected claim costs at the time, and the potential for additional losses to emerge – even years after the original contracts were written – prompted the insurer to seek capital relief. In a similar strategy, Aspen Insurance transferred $125.5m of US primary casualty reserves to SunPoint earlier this year, simultaneously securing retrospective reinsurance coverage for the 12 months ending on 31 December 2017. 
Cost of capital
In today’s environment of disruption, the cost of capital is more important than ever for insurers and reinsurers. As carriers leverage advanced analytics and innovative models for greater understanding of their risk profile and expected returns, the use of contingency capital to support capital-efficient balance sheets will empower them to nimbly reallocate resources away from underperforming business to finance more promising market opportunities. The same can be said for reinsurers, who will also enjoy greater return on risk capital under new, more robust solvency regulations. And all industry constituents will gain the added flexibility to customise products and solutions for their clients. A 
David Priebe is vice chairman with Guy Carpenter & Company. Guy Carpenter & Company provides these responses for general information only. 
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