The alternative capital partnership matures. But what about the reinsurance cycle?

As the busy reinsurance conferencing season approaches, kicked off in September by our Artemis London 2024 ILS market event and soon after the Monte Carlo Reinsurance Rendezvous, it’s perhaps no surprise that talk of the reinsurance market cycle re-emerges.

In a new report from AM Best on the fact reinsurers met their cost of capital for the first time in four years in 2023, the rating agency raises this topic and we think rightly so at this time.

In the past, we’ve heard everything from calls for the reinsurance cycle to be smoothed and moderated, to it being flatter going forward, or more localised in terms of its peaks and troughs, less violent in terms of its movement, to the outright death knell for the reinsurance underwriting cycle being tolled.

Often, the growth of alternative capital and insurance-linked securities (ILS) have been cited as the reinsurance cycle killer.

As the last few years have shown, those calls were far too early and the reinsurance cycle rebounded with a vengeance.

Of course a significant driver for that rebound was due to recognition of the erosion of profitability that had occurred in the reinsurance and ILS sector, driven by a very softened market, over-stretched terms of coverage, overly exuberant underwriting and then a challenging few years of catastrophes and severe weather that drove attrition, volatility and large losses through the market over consecutive years.

Of course other things happened that have also affected the cost-of-capital in the industry and accentuated the need to get adequately paid for deploying it, from capital market shocks to a global pandemic in the intervening years.

This time after the dust has settled, from AM Best, its reference to the market cycle being subdued is really in relation to the need for reinsurance companies (and ILS managers, funds or structures) to deliver a profit and generate an attractive return for their investors, which seems a more productive place to re-boot the discussion from.

In fact, we’re now at a far more nuanced stage of the reinsurance market’s development, especially in its use of alternative and ILS capital, so this could stimulate a far more productive discussion at the upcoming busy conferencing season.

AM Best said, “Sound risk management, strategic use of technology, and a maturing partnership with alternative capital have subdued the cyclical nature of the reinsurance market by narrowing the extremes.”

It’s good to see AM Best speaking about a “maturing partnership” as this has really become increasingly evident over the last few years.

Catastrophe bonds have grown in importance for sponsors and sponsors increasingly seek them out as they expand reinsurance towers higher.

Third-party capital is also becoming deeply important as a balance-sheet expansion tool. That pool of complimentary and aligned risk capital that many major reinsurance firms now manage, or welcome into structures that sit alongside them.

Just yesterday we broke the news on two new aligned third-party capital units at major re/insurers, Ariel Re Capital Partners and Ascot’s new Leadline Capital Partners. These activities are becoming increasingly formalised and now re/insurers need to be able to differentiate as well, as they too compete for third-party capital.

At the same time, private ILS, collateralized reinsurance and retrocession arrangements, are becoming more widely used again and beginning to see something of a resurgence, as investors realise the qualities of the reinsurance market have changed.

This speaks to the capital elasticity that we discussed back in 2017 and we continue to see alternative capital in use by many re/insurers as a way to make their own balance-sheet capital go further, or work harder for them, with third-party capital delivering a growth engine and a shock absorber at the same time.

AM Best’s report speaks to the way the quality of returns available in reinsurance have improved and this is really key to why things might be a bit different this time.

The rating agency gives the backdrop as, “The current hard market came about due to prolonged underperformance and economic and social inflation, and despite a relative abundance of capital, due to the prolonged low interest rate environment. Rate increases are slowing down—Guy Carpenter calculated a 5.4% increase in Rate-On-Line (ROL) at January 1, 2024, for both US and European property catastrophe reinsurers, compared with nearly 30% in 2023 — but reinsurers have also implemented thorough de-risking measures such as tightening terms and conditions and sharply increasing attachment points, which are unlikely to be relaxed.”

It is those de-risking efforts and the reinsurance reset that has seen attachments lift higher, while attrition has been pushed back in many cases to the primary tier of the market that have made a significant difference and are one key reason for the attraction to reinsurance being shown by investors right now.

That said, in our conversations with investors, there’s a lack of understanding of just how much difference this has made. Investors often see the headline rate improvements, but the improvements in the quality of investment opportunities, thanks to this derisking by reinsurers and ILS managers is what’s really driven a significantly better investment opportunity today.

Reinsurance and retrocession instruments are more remote in terms of attachment and far more removed from the kind of volatility and attrition that investors were badly impacted by through a number of years from 2017.

The reset in risk-sharing, between primary and reinsurance, or reinsurance and retrocession, has made a significant difference to the performance-potential of portfolios of risk, as well as in catastrophe bonds.

The resent in risk-sharing has also helped to drive the ability for reinsurers to beat their costs-of-capital, which is what their investors and shareholders had needed to see. At this time there appears no desire to backtrack on any of the improvements in terms and attachments that have been seen.

“The hardened market has led to more sustainable pricing momentum, enhancing reinsurers’ ability to meet their cost of capital over the medium term,” AM Best said.

Adding that, “To meet or go above the cost of capital, reinsurers must remain flexible with regard to market conditions and balance opportunistic moves (taking advantage of market conditions, retreating when pricing is not right) over the short term, with strategic long-term goals (maintaining relationships, building expertise, and being relevant and dependable over the long run).”

While the results of this reinsurance reset, in pricing and terms, are now clear as, “In 2023, reinsurers generated returns well above the cost of capital due to positive underwriting results, driven by repricing and de-risking of reinsurance portfolios.”

Which means reinsurers have just had a taste of what this means and while it takes time for that to filter through to every shareholder, the analyst share price consensus for many reinsurers is up and likely to stay higher while discipline remains.

It’s no surprise, that at this time of a more balanced and profitable re/insurance environment, third-party capital is becoming ever more embedded within it.

Some might find that a strange statement, as you’d think re/insurers might rail against ILS and third-party capital at just the time they can generate the highest profits from their underwriting.

But, the reinsurance reset has changed the game somewhat, partly with the help of inflation, social inflation and fear of climate change effects on loss frequency and severity.

Resulting in a need for re/insurers to be more protective of their balance-sheet capital and to buy more protection as well, and at different layers of their towers, all of which has driven an opportunity for ILS and third-party capital to be welcomed in and to deepen the alignment over the last year.

We’ve moved beyond the discussions of competition. The tone of conversations between traditional and alternative markets has changed somewhat, in many circles.

Which is why we think the conversation can be more productive going forwards, as the re/insurance industry seems ready, in our view, to really explore just how additive alternative capital and institutional investors can be to their businesses.

Well some were quick to say we’d converged a few years ago, that convergence was clearly not an equal partnership at the time. The industry is now in a better place for a convergence to truly occur, to the benefit of all the stakeholders, capital providers and managers of risk that are involved.

Because still, investors aren’t really interested in standing up new companies right now. For one there’s little need for them. For two, these “class of” start-ups always seem to adopt the same business model as the more established players and most haven’t offered any real differentiation (or alpha) to get an investor excited.

But investors are very interested in accessing the returns of the underwriting market still, at this time post-reset when the profit potential of reinsurance allocations is so much improved.

Which is why conversations between re/insurers and investors, as well as with ILS managers, are so much more productive right now.

Finding the right way to inject efficient capital into your reinsurance business to turbocharge its growth, while moderating and managing volatility, is a super-opportunity for the sector and one that shareholders can also get onboard with.

All sides are aligned that third-party capital is a positive component of the global reinsurance market, which is why AM Best’s mention of the “maturing partnership” is both apt and timely, so something worth having a conversation about.

It’s also worth noting AM Best’s analysis that investors are increasingly more interested in allocating capital to structures that can deliver the profits from reinsurance without the start-up costs and often challenging exit.

Which is where ILS steps in to provide a flexible and efficient allocation alternative, while still enabling management teams and underwriters in the industry to get ahead and grow.

So we now see ILS growing again, reflecting both the maturation of the partnership with the re/insurance industry and also many investors deciding ILS is an optimal way to access and benefit from reinsurance market returns.

Finally, while the reinsurance cycle may come up for some discussion over the conferencing season this year, that’s not to say we think its dying.

But, we do think the industry as a whole has much more to gain from maintaining pricing and terms at a level that allow for profitable underwriting across the cycle, keeping capital attracted, and we think that after some difficult years that has been realised by many on both traditional and alternative sides.

Which does mean the cycle could be more subdued, as AM Best suggests, at least for a time, as the partnership with efficient capital becomes increasingly deeply embedded within business models.

A spark of disruptive innovation within re/insurance or capital markets could change things dramatically, of course.

So if anyone achieves the holy grail, of designing a way to raise, channel and deploy large amounts of very efficient institutional capital more directly to insurance risk-linked opportunities and with greater liquidity available, all bets could be off on the future for the reinsurance cycle.

Although that would perhaps be more likely to ring the death knell for some business models, rather than the way prices and terms move within this industry.

Join us at our Artemis London 2024 ILS market conference on September 3rd to kick off the conferencing season.

We’ll be at the RVS in Monte Carlo as well, so reach out if you want to meet up and talk about the continued evolution of the reinsurance market.