September 7th, 2008

Capital Constraints: The New Reality?

Posted at 5:44 PM ET

Mark Hewett, Chairman of London Operations
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For several years, carriers have enjoyed a period of low insured losses, and access to cash has not been a problem. Traditional sources have been bolstered by the largesse of hedge funds, private equity funds, and even the wealth of high-net worth investors through a variety of insurance-linked securities (ILS). But, credit market turmoil has brought these conditions to an unceremonious close.

In terms of insured losses, we all know that the years since Hurricanes Katrina, Rita, and Wilma struck have been pretty calm. Carriers have had to struggle to find uses for excess capital, from mergers and acquisitions, to repatriation. In 2007 alone, for example, carriers in the Guy Carpenter Bermuda Composite sent USD2.3 billion back to investors through dividend payments—nearly 20 percent of net earnings for the group.

Financial market developments have clouded the recent success of (re)insurers, though. The collapse of the subprime mortgage market last year continues to reverberate worldwide. While direct carrier exposure—through directors and officers (D&O) and errors and omissions (E&O) insurance—generally appears to have been contained at this stage, the ensuing credit crisis has impeded access to capital. As a result, (re)insurers have lost an important source of cash, demonstrating that it doesn’t take a physical catastrophe to change the marketplace. The implications could be even more severe if a natural or man-made catastrophe does occur.

Throughout the capital-rich years of 2006 and 2007, alternative investment vehicles became quite engaged in facilitating risk transfer. Hedge funds and private equity funds, for example, sought investment opportunities that were not correlated with broader financial markets, and risk-bearers were hungry for the depth afforded by capital markets.

The alternative investment community, of course, has had plenty of capital to provide. Private Equity Intelligence, Ltd estimates that hedge funds and private equity funds together held close to USD5 trillion in assets under management globally. Further, the London-based research firm reports that, at the end of 2007, private equity funds alone had USD820 billion in “dry powder” (i.e., uncommitted capital). More than 40 percent of private equity capital was sitting on the sidelines.

The (re)insurance community, buoyed by several years of low losses and a world awash in investable assets, has acted as though capital wouldn’t be constrained any time soon. The tide, however, is turning. The subprime event has sent capital markets into disarray, and it could become the largest casualty “catastrophe” in history. At the same time, the alternative investment community is feeling the effects of the tightening credit market. The situation could worsen before improving.

What else could go wrong?

It’s no secret that reinsurers suspect the odds of a major property-catastrophe event are on the rise. While this has not been sufficient to affect pricing, it does lead many to wonder about the availability of capital following an event. If a large storm—or series of storms, earthquakes, or other natural or man-made catastrophes—were to strike and cause substantial insured losses, (re)insurers would need to replenish depleted balance sheets quickly by engaging many sources of capital.

In addition to traditional reinsurance capacity, carriers would look to sidecars, catastrophe bonds, and direct equity investments to fuel a return to the status quo. In the wake of the subprime crisis, though, capital from these sources could become expensive, if it is available at all.

Any risk-transfer vehicle—from treaty reinsurance to industry loss warranties (ILWs)—is only as useful as the capital it provides. If investors are unable or unwilling to finance (re)insurer risk transfer, the cost of capital will be driven ever higher, requiring the use of cash that carriers could deploy elsewhere. Typical post-catastrophe pricing dynamics would be exacerbated, with both cedents and reinsurers struggling to manage risk effectively.

Instead of waiting for the next catastrophe to affect balance sheets and harden pricing, risk-bearers would be prudent to address the likelihood of capital-constrained market conditions now. Advantageous pricing still exists for both traditional reinsurance and ILS, making it easier for (re)insurers to take action. However, the market is speaking, and savvy risk-bearers will listen. One mega-catastrophe could topple today’s precarious balance.

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