February 20th, 2013

Adapting to an Evolving Market of More Permanent Capital Market Capacity

Posted at 1:00 AM ET

ezbiansky_chris_biopotter_des_photograph1Christopher Ezbiansky, Mergers and Acquisitions Advisory - Americas and Des Potter, Mergers and Acquisitions Advisory - Europe, GC Securities*

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A new capital management paradigm is challenging the traditional reinsurance model. Historically, significant market losses from major catastrophic events and low investment yields were a catalyst for an improved rate environment. Faced with current economic conditions, reinsurers are finding it more difficult to generate adequate returns in excess of their cost of capital, and are seeing an increased competitive threat from alternative capacity from the capital markets. New money appears to be more permanent and therefore limits the firmness and duration of any improved rate environment. Catastrophe bonds, sidecars, structured industry-loss warranties and collateralized reinsurance vehicles are among the alternative market options. Hedge funds are also playing a more active role, with a couple of major names setting up reinsurance operations in Bermuda.

This article addresses evolving trends in the marketplace, the generation of new funds and growth opportunities that extend beyond traditional reinsurance.

Capital Position Increases

Insured catastrophe losses exceeded USD110.0 billion in 2011, setting a new record. In spite of absorbing the major burden of these costs, reinsurers reported a capital position in excess of historic trends and a stable rate outlook. The capital base of Guy Carpenter’s Global Reinsurer Composite increased to USD177.2 billion or 2.0 percent in 2011, and improved another USD9.6 billion or 5.4 percent to USD186.96 billion at June 30, 2012.

In the current environment, the challenge of generating an adequate return in excess of a company’s cost of capital is discounted in sector valuations. The weighted average cost of capital (and the mean consensus for 2013) is estimated in the chart below.

weightedavgcapital72

Conditions are favorable for management to evaluate traditional reinsurance model efficiency, particularly in capital intensive classes of business, such as property catastrophe reinsurance. In these cases, competition from new alternative market vehicles has softened rate volatility following major catastrophe events and shows signs of changing market dynamics by dampening the rate outlook. Inflow of new capital has been significant - USD6.0 billion to USD8.0 billion has entered the market since the 2011 catastrophes.

Guy Carpenter’s U.S. Property Catastrophe Rate on Line Index shows the adequacy of catastrophe rates compared to market lows from 1998 through 2000. There is less volatility and a decline in the average five-year trend line.

propcatrateonline72

New Generation of Funds

Guy Carpenter estimates that alternative markets provide 14 percent of the aggregate property catastrophe limit purchased. Penetration is growing as fund managers with scale and a proven track record of delivering a high-yielding, uncorrelated asset continue to attract new institutional money. This new generation is able to offer comparable products and, in some areas, pricing at more competitive terms than the traditional reinsurance market, due to expectations for a lower cost of capital and return.

In contrast to the new capital that was deployed in sidecar vehicles after Hurricane Katrina, this institutional funding has a longer investment horizon. It is also likely to become a permanent and growing source of capacity for buyers of property catastrophe reinsurance.

Other Investment Strategies

Simultaneously, the hedge fund community is gaining prominence, attracted by the permanence of a reinsurance vehicle as a source of assets for investment strategies. New players include PaCRe Ltd., Third Point Re and SAC Re, which was launched in July 2012.

More opportunistic investors are seeking market dislocations to offer returns in the low 20 percent range on an expected loss basis and the high 30 percent range on a no loss basis. Rates are currently available primarily in the retrocession market.

New alternative market vehicles are reminders of how quickly capital can flow into the sector at a time when most reinsurance companies are trading at a discount to book value. In response to these market conditions reinsurers are returning capital to shareholders via buy backs or special dividends as market opportunities to deploy surplus economic capital for an adequate return diminish.

Third Party Fund Management

Guy Carpenter’s investment banking arm, GC Securities , observes that its clients are challenging the traditional reinsurance model. Some firms are adopting strategies similar to that of Renaissance Re (and more recently, Validus Re) by establishing an operating division to attract and manage capital from third party investors. This allows reinsurers to securitize the most capital intensive parts of their business, while providing valuable capacity to their insurance clients and generating a new source of “capital light” revenue.

A third party fund vehicle managed by a reinsurance company may not conform to the tight governance requirements of most institutional investors, such as pension or endowment funds. However, the depth of underwriting and claims management experience affords reinsurers a competitive advantage over fund managers.

When considering a strategic move, a reinsurer with a dominant property catastrophe portfolio should ask: What is the differentiating proposition and who are the target investors? It is not simply a case of ceding a quota share of its existing property catastrophe business. The reinsurer needs to address investor expectations about fiduciary responsibility, risk allocation, valuations, liquidity and reporting.

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*Securities or investments, as applicable are offered in the US through GC Securities, a division of MMC Securities Corp. (”MMCSC”), a US registered broker-dealer and member FINRA/SIPC. Main office: 1166 Avenue of the Americas, New York, NY 10036. Phone: 212.345.5000. Securities or investments, as applicable, are offered in the European Union by GC Securities, a division of MMC Securities (Europe) Ltd., which is authorized and regulated by the Financial Services Authority.

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