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Alternative capacity and strategic reinsurance

Source: Asia Insurance Review | Dec 2016

Mr Clarence Wong of Swiss Re discusses the outlook of alternative capacity as it competes with traditional reinsurance in today’s soft market.
 
Highlights
  • To date, alternative capital is mostly focusing on US property cat risks, which accounts for approximately US$10 billion of premiums; 
  • Alternative capacity is uncompetitive in comparison with traditional reinsurance, particularly in Asia where traditional capacity remains abundant; and 
  • Alternative capacity is here to stay, however, it is unlikely to spread significantly beyond peak risk segments.
 
Alternative capacity (AC) has grown strongly in the past decade, boosted by favourable circumstances: low catastrophe activity of recent years leading to attractive margins and comparatively low returns in other asset classes. 
 
Understanding alternative capacity
After years of rapid expansion, AC and its global market share in the property catastrophe segment have largely stabilised in 2015/16. Estimates suggested that AC accounts for around 16% of today’s global CAT XL market and 23% of the US market (excluding retrocessions). The inflow of new money is slowing as AC funds are also struggling to find attractive opportunities in the current soft market.
 
   At the same time, there are indications that the market has become more mature and sophisticated. Over the years, the investor base has broadened and many investors have recognised the attractiveness of catastrophe bonds as a truly diversifying asset class. 
 
   New financial market technologies and modelling tools, as well as increased competition among various service providers, have resulted in reduced frictional expenses associated with issuing a catastrophe bond. Investors have also become more comfortable with indemnity-based triggers or structures. 
 
   To date, alternative capital is mostly focusing on US property CAT risks, which accounts for approximately US$10 billion of premiums. This segment is short-tail in nature, fairly transparent with regards to the provided insurance cover, supported by a number of vendor risk models, and has low entry barriers. 
 
The rise of strategic reinsurance
Alternative capital is not well suited for the great majority of reinsured risks which are not peak risks, not supported by risk models and are long-tail business. The higher complexity of underwriting non-CAT risks and the cost of collateralising makes AC uncompetitive in comparison with traditional reinsurance. This is particularly the case in Asia where traditional capacity remains abundant due to keen participation by both international and regional reinsurers. 
 
   AC is short-term (except for multi-year ILS), opportunistic and transactional. By contrast, reinsurance programmes are increasingly customised to help insurers optimise their capital structure, improve capital returns and minimise capital costs. 
 
   More often, reinsurance is integrated into insurers’ long-term strategy and growth plans. These structures are complex and often result from long-term relationships. The demand for structured and more strategically-motivated (re)insurance programmes is growing across the region. The rationale for the use of such solutions has evolved into three broader motivation areas.
 
1. Increasing the efficiency of risk transfer
Structured (re)insurance programmes can increase the efficiency of risk transfer by combining multiple risks and/or interdependent triggers. As part of a more integrated risk management process, risk transfer is focused on the joint distribution of all risks, helping to expand the insurability of difficult-to-insure risks. 
 
2. Optimising capital structure, reducing cost-of-capital and improving capital efficiency
Reinsurance can also be used for corporate finance purposes, that is, to address capital management issues. Corporate finance-oriented solutions include non-life retrospective covers and life in-force monetization, with the goal of releasing “trapped” capital and monetizing future expected cash flows on long-term business.
 
3. Enabling strategy and growth
The third motivation for the use of customised solutions is to enable the strategic and long-term growth objectives of a ceding insurer. In the life sector, reinsurance contracts can help an insurer finance the high first-year expenses and negative cash flows associated with the growth of new business. In the non-life insurance sector, support is more focused on flexible, on-demand capital relief and capital efficiency. 
 
Outlook for alternative capacity
Alternative capacity is here to stay. However, not all AC business models are equally resilient. Collateralized reinsurance, sidecars and hedge fund reinsurance are increasingly deployed in working layers and primary insurance. 
 
   ILS is applied in higher layers and more based on modelled CAT risk which is better understood by investors than the business risks of pricing and underwriting quality. CAT bonds have a proven track record through the years of financial market turmoil and record high CAT losses. There also had been few events where bonds were triggered so there is some collective experience for CAT bond investors.
 
   AC (particularly CAT bonds) is the main force behind the commoditization of property CAT reinsurance. It will continue to have an impact, although with less momentum, even as reinsurance rates soften further, catastrophe losses increase, and as rising rates make other investments more attractive. However, AC is unlikely to spread significantly beyond peak risk segments.
 
Mr Clarence Wong is Chief Economist Asia at Swiss Re.
 
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