The enormous growth of alternative capital in to property catastrophe reinsurance is arguably the single most significant change in the overall (re)insurance market of the last decade. The supply/demand balance for property catastrophe reinsurance in particular has fundamentally altered, with Guy Carpenter’s Rate on Line index falling 31% between 2013-2017 (of course helped by benign cat years). Even after 2 years of significant losses, it is unlikely prices will return to what was seen in the ‘hard market’ of 2010 and 2011 again.
The impact of ‘alternative’ reinsurance capital has also elevated the concept of ‘economic returns’ (that is, factoring in the cost of capital) in the attention of the wider insurance industry. Insurance groups are now asking whether ‘capital agnosticism’ – using whatever capital source can most efficiently back a given pool of risks – can apply beyond property catastrophe risks, and whether reinsurance can be utilised as a fundamental lever of corporate finance (alongside debt and equity) to ultimately reduce the overall cost of capital.
Meanwhile, a growing number of investors recognise the benefits of (re)insurance risk in their portfolio. As the market grows in sophistication and institutional investors become more comfortable taking longer term bets on this noncorrelating asset class, we are seeing the emergence of new structures that could support a wider array of business lines.
It doesn’t seem long ago that there was a clear distinction between ‘traditional reinsurers’ (with capital requirements set by regulatory solvency models and supported by large back offices) and reinsurance SPVs (fully collateralised and administratively light). Now there is an ever growing variety of structures in the ‘grey area’ in between. Greenlight Re, created 15 years ago, was perhaps the first of the ‘hedge fund reinsurers’, writing business for its cashflow profile to invest the ‘float’ between premiums received and claims paid.
Now, a new trend is emerging for institutional ILS investors to set up ‘balance sheet’ reinsurance sidecars - with a solvency capital requirement (and potentially a credit rating), rather than being fully collateralised. One term for these new structures might be ‘lean reinsurers’. Like a sidecar, these take a reinsurance or retrocession from a ‘host’ cedant, which is also responsible for the administration of the new entity. However, as they use a regulatory solvency model to set capital requirements (which recognises diversification and the differing volatility of various business classes), the capital requirements of these vehicles can be considerably lower.
Possibly the largest known example of this is Vermeer Re, an AM Best ‘A’ rated joint venture between Renaissance Re and PGGM, a Dutch Pension Fund. In this example PGGM has committed USD 600m, with the option of increasing to USD 1bn, to capitalise a new reinsurance company which will write retrocession business with aligned interests to Renaissance Re. Renaissance Re will also be responsible for providing the management functions of the joint venture, and benefits from increased capacity and the opportunity for ‘hybrid earnings’ – fee income to complement its underwriting return.
For investors, it is easy to see the attraction of more capital efficient vehicles when one considers the problems caused by trapped collateral in the ILS fund industry. As well as improved IRRs, this also opens up the possibility of supporting other lines of business, including lower volatility, longer tail lines with a greater reserve component, or higher layers of Cat XL treaties where the rate on line doesn’t provide sufficient return on collateral for a typical ILS transaction
However, there is a price for this. This is a long term venture between investor and cedant insurer, so making the right choice concerning who to partner with is fundamental, and robust controls need to be drawn up to ensure aligned interests and appropriate governance. As the equity of a reinsurance company is fungible, all the investments from underlying investors are commingled, and any new investor in to an established vehicle may well be as exposed to reserve risk as they are to prospective insurance risk. Investors need to consider what their exit strategy is. Although run ‘lean’, these new entities will have to ensure they have the right licences, and there is a great amount of variation around what different regulators expect and allow, making the choice of what jurisdiction to domicile in crucial.
Exactly what structure to use depends on the unique circumstances of the capital provider and the insurer. A combination of factors – lines of business, nature of underlying investors, their time horizon, profitability of the ceded business, management time available, exit strategy, distribution network, scale, past experience with ILS, office locations, and several others - all have a bearing on determining the best option. Lean reinsurers may be a new term but it is a broad church encompassing Bermudian carriers, Lloyd’s special purpose arrangements, cells collateralised by corporate guarantee in Guernsey, and many other structures. Having a clear strategy outlining ambitions for a lean reinsurer is an important first step to success.
The securitisation revolution opened up property catastrophe reinsurance to third party capital. Lean reinsurers may be the mechanism to knock down the barriers to entry for other (re)insurance risks, ultimately shrinking the value chain between risk and capital.