Earlier this year, the (re)insurance industry celebrated an abundance of capital. Buybacks and dividends were common, as carriers struggled to find productive uses for their extra cash. Only a few months later, we are in the midst of a financial catastrophe that is wreaking havoc on balance sheets and constraining carrier access to capital. And, the situation could worsen. A major catastrophe event could place substantial demands on (re)insurer capital in a climate where replenishment would be both time-consuming and costly.
What began as a subprime mortgage default trend has exploded into a global financial catastrophe, decimating carrier balance sheets and causing capital to disappear from financial markets around the world. The destruction of shareholder wealth has been profound, with implications that reach far beyond investor portfolios. Limited access to capital (at best) has pushed its cost higher for all companies, but the problem could be particularly troubling for (re)insurers. Our industry runs on capital, and if it is not readily available, effective risk management is essentially halted.
Credit markets have been in disarray for the past year, with even ostensibly low-risk, short-term vehicles incapable of bringing fresh capital to carriers. Equity markets have offered little consolation. Clearly affected by the demise of credit markets, equity valuations have been pushed downward, and the cost to raise money in this manner has spiked. The result is an overall increase in the cost of capital across the industry, which is bound to exert some upward pressure on risk-transfer pricing even if it is not sufficient to turn the market.
Over the past few years, the outsized growth of the alternative investment community has made it a rich source of capital for (re)insurers, but this role is likely to change. Neither hedge funds nor private equity funds have been immune to the machinations of the financial catastrophe. The evaporation of credit capital obviously has impacted both business models. Private equity funds, still awash in cash, are committing more of it to deals than they had in the past, implicitly shrinking investing power. Further, the alternative investment community has had to cope with the erosion of investment asset value—just like (re)insurers.
Some corners of the hedge fund and private equity fund community have been able to outperform the market throughout the credit crisis and ensuing financial catastrophe. In general, though, they are being attracted to opportunities in distressed debt market, which are perceived to offer the potential for substantial returns. Consequently, capital from these funds is implicitly constrained by the location of market opportunities.
While catastrophe bonds, sidecars, and other capital markets vehicles have been touted as alternative sources of capital for (re)insurers, they may be affected by the financial catastrophe as well. A risk-transfer tool is only as effective as the capital it contains. Thus, an industry-wide liquidity problem could impede the flow of capital to catastrophe bonds and sidecars as much as it does to direct equity and credit markets. At present, however, there appears to be sufficient capital available to support the capital markets-based transfer of insurance risks. Dedicated reinsurer and insurance-linked securities (ILS) fund capital have held up well through the financial catastrophe, with these entities well-positioned to provide crucial capital to the industry.
The short-term will be challenging for the (re)insurance industry, particularly following a significant catastrophe event. Instead of waiting for the next big storm, carriers should begin planning now. In addition for identifying ways to replenish balance sheets post-loss, it pays to take preventive steps to reduce the impact of a mega-catastrophe, particularly when the cost of capital is already on the rise. Transferring stubborn risks out of the portfolio is an important first step, but it should occur in the context of a broader capital management effort. Carriers that think ahead of the market are most likely to be rewarded later.