Industry Must Adapt to Emerging Segmentation Phase
Pricing declines continued in the insurance-linked securities (ILS) segment of alternative capital. In turn, this has prompted questions about the sustainability of lower pricing and capacity post-catastrophe event, suggesting that traditional reinsurers’ models and the traditional reinsurance and alternative capital mix of capital sources still need to evolve. Maintaining premium rate adequacy and stable capacity requires better access to the expanding sources of capital and awareness of the benefits of better risk syndication and segmentation, according to David Priebe, Vice Chairman at Guy Carpenter and Cory Anger, Global Head of ILS Origination and Structuring at GC Securities.
This year the ILS segment of alternative capital pricing continues to decline as excess risk capital is available and the demand for risk transfer limits remains flat to slightly down. “A deeper understanding of the supply/demand relationship for risk transfer limits requires a thorough analysis of the particular market taker’s cost of capital and premium rate level adequacy and cedents’ efforts to fully access and utilize the capital most efficiently,” says Mr. Priebe.
“GC Securities’ review of target returns of superannuation funds (1) reveals that the largest and most stable portion of alternative capital - pension funds, sovereign wealth funds and endowments - is still priced adequately despite significant premium rate reductions since 2012,” says Ms. Anger. “Pricing is likely to remain adequate even with projected rate declines (subject to industry loss activity) for the remainder of 2016 and into 2017.”
“Traditional reinsurers are able to lower their cost of capital through their own use of alternative capital as they replace equity capital with collateralized retrocession (2), sidecars, collateralized quota share reinsurance and repositioning of books of business through strategic underwriting practices,” asserts Mr. Priebe. “Despite the companies’ use of alternative capital, however, traditional reinsurer equityholders’ returns have not improved.”
According to a GC Securities analysis at mid-August 2016, Bermuda reinsurers’ 2016 average return on equity is estimated at approximately 7.6 percent, down from 10 percent in 2015. “Alternative capital sources can accommodate further premium rate reductions and still maintain price adequacy,” says Ms. Anger, “but traditional reinsurers may not be able to withstand rate declines with their already subpar equity returns.”
“Historically, traditional reinsurers increase their premium rates after industry catastrophe events in order to replenish capital and attract new capital, with the goal of reaching overall premium rate adequacy and restoring returns on equity to levels more consistent with what is expected of equity capital,” Mr. Priebe explains. “However, GC Securities has found that significant pricing increases will be difficult to sustain for short periods because of the inflow of new capital that typically follows catastrophe events. Alternative capital is already making contingency plans with funds created so that they can inflow new capital rapidly post-event. The difficulty in sustaining price increases means that premium rate adequacy is even more critical in soft markets when capital is abundant. (Re)insurers need to evolve by reassessing business models for more efficient allocation of risk to capital sources.”
“GC Securities envisions an environment in the future where segmenting sources of capital to different risk profiles of a risk transfer program may improve efficiency for cedents and capital providers,” Ms. Anger states. “It might be most efficient for traditional reinsurers to focus on working reinsurance layers where claims departments can be leveraged for loss frequency layers and alternative capital to focus on non-working severity layers where they are best able to absorb low frequency, severity losses at the lowest cost of capital.”
Cedents’ willingness to open the accessibility of their entire risk transfer program to all capital sources is also a key factor in determining pricing efficiency and minimum premium rate levels. “Many cedents would like to see minimum premium rate barriers lowered,” says Ms. Anger, “but another way of achieving pricing efficiency is to open reinsurance programs to all sources of capacity instead of limiting ‘all sources access’ to only select risk transfer layers. Open access to all (re)insurance and retrocession program layers is critical for avoiding the situation where less competitively placed reinsurance layers subsidize the premium rates on ‘all sources eligible’ competitive risk transfer layers.”
Ms. Anger further states that the ability to lower minimum premium rates for remote high severity loss layers is affected by the continuum pricing level to risk level relationship across the entire risk transfer program in addition to the specific layer’s pricing to risk level ratio. If the competition among risk transfer capacity sources results in all layers pricing lower, then alternative capital may be able to justify lower minimum premium rate pricing from prior levels.
Mr. Priebe concludes: “The unique collaboration of Guy Carpenter brokers and GC Securities professionals provides clients with agnostic advice regarding risk transfer sources. Guy Carpenter places and accesses risk with all types of capital sources as we advise clients through this emerging segmentation phase that we expect will benefit cedents and capital sources.”
1. Based on review of superannuation funds’ annual reports. For example, the New Zealand Superannuation Fund has a minimum return hurdle of Treasury Bill return plus 2.7 percent over any 20-year moving average period; Australia’s Future Fund seeks to achieve an annual return of at least Consumer Price Index plus 4.5 percent to 5.5 percent; and U.S. pension funds targets as disclosed in their annual reports.
2. Two thirds of the industry’s overall retrocession limits are sourced from alternative capital, according to Guy Carpenter.
*Securities or investments, as applicable, are offered in the United States through GC Securities, a division of MMC Securities LLC, a US registered broker-dealer and member FINRA/NFA/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. (MMCSEL), which is authorized and regulated by the Financial Conduct Authority, main office 25 The North Colonnade, Canary Wharf, London E14 5HS. Reinsurance products are placed through qualified affiliates of Guy Carpenter & Company, LLC. MMC Securities LLC, MMC Securities (Europe) Ltd. and Guy Carpenter & Company, LLC are affiliates owned by Marsh & McLennan Companies. This communication is not intended as an offer to sell or a solicitation of any offer to buy any security, financial instrument, reinsurance or insurance product. **GC Analytics is a registered mark with the U.S. Patent and Trademark Office.