The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

Search archive

Advanced search

2009 is the year of reinsurance capital. While the capital markets were petrified into inactivity, reinsurance came powering to the aid of insurers, enabling them to plug holes in their capital requirements, bulk up their business plans and to act as surrogate equity or debt when none was available.

"Reinsurance, in effect, became the only game in town"

It's quite a success story. So as the industry heads for Monte Carlo and the annual circus that traditionally opens negotiations for the 2010 renewals, a degree of self-satisfaction among the 2,000 or so attendees is forgivable. The masters of the universe failed; reinsurers, on the other hand, passed the test again. As with Katrina, WTC and Hurricane Andrew, the industry stood firm when insurers required it to do so.

But amid the half-hour meeting slots, fizz-fuelled receptions and opulent client dinners, there is no room for complacency. Indeed, there is even a danger that the industry may miss a unique opportunity to re-engineer the value proposition that is the reinsurance capital model.

Capital markets thaw
The capital markets appear to be thawing after the big freeze and we can see the early evidence: in particular, equities, led by financials and commodities, have recovered strongly since the lows in March. For example, by 24 August the MSCI World index was up 58 percent from its 9 March low to a ten-month high. Anecdotally, there are also suggestions that quota share reinsurance transactions - which have enabled capital-starved insurers to still gear-up this year despite their bankers failure to raise finance from the capital markets - are being cancelled because insurers are again being promised access to more permanent (and frankly, expensive) capital.

Does this matter?
It does because a small, but quite seismic, shift began to take place last year among the industry's clients. If you asked buyers what they really thought of reinsurance, then until recently it is likely that phrases such as "plugging a hole" or "playing the pricing cycle" would have been bandied around.

Reinsurance was neither an expensive luxury nor an affordable necessity: it was - at least to some clients - simply nice to have when the price was right. As an insurer, your capital base was built from the ground up with equity, debt and hybrid layers. Only once this was completed would insurers start looking at the various additional layers - such as reinsurance, contingent capital and insurance linked securities - and arbitrage dependent on pricing, availability and demand.

Of course, there are exceptions. If you are a thinly capitalised US mga writing Florida wind, you need (re)insurance capital before anything else. But the reality was that to some of the industry's customers, reinsurance was an undifferentiated form of capital. It also explains why the market has remained relatively static at around $200bn-$225bn in terms of life and non-life gross written premiums.

But the collapse of Lehman Brothers and American International Group (AIG) in September 2008 shattered many conventional ideas. It used to be: "who cared if we blow through capital, we'll just reload" - as demonstrated by Montpelier Re in 2005. The short-tail specialist began that year with $1.75bn in shareholders' equity but was then hit with $1.2bn in devastating cat losses, including Hurricane Katrina. In theory, this should have smashed the Bermudian firm onto the rocks that surround the reinsurance archipelago like the Sea Venture - the flagship of the island's 17th century founder Sir George Somers. Instead, Montpelier Re ended the year with a satisfactory $1.06bn of shareholder equity, as it was allowed to swiftly rebuild its capital base with a host of measures, including a $600mn equity raise, sidecars and debt.

By late last year, however, the phrase "unreplenishable capital" began to take grip. And as the capital markets were slammed shut, (re)insurers were given a terrible shock - their capital pipeline had closed at a time when many were spying greenfield opportunities. Instead, what they had on their balance sheet was it; for fresh capital, they would have to look elsewhere.

Reinsurance, in effect, became the only game in town. Carriers such as Swiss Re (via Berkshire Hathaway), Ironshore (led by Swiss Re this time) and Chaucer (led by Flagstone) all entered into major quota share transactions to underpin their 2009 underwriting plans. They did so because the equity and debt markets - normally their first port of call - were closed. Capital relief/stop loss transactions are also increasing, according to anecdotal evidence. In other words, reinsurance has become not just a method of transferring peak risk, but an alternative source of capital.

And with the capital markets in full retreat, the reinsurance industry is defying the gloom and actually growing. If the global market reinsurance market was worth circa $200bn-$225bn, it has possibly grown closer to $250bn this year. Even where providers of non-life (re)insurance capital have had major scares this year - i.e. AIG, the Hartford, Swiss Re and XL Capital - it is because they steered off the main drag and were pretending to be investment banks or had failed to hedge their non-P&C exposure limits, such as variable annuities or bond guarantees.

Scarce and powerful
In fact, when you think of reinsurance as a form of hedge capital, it is more than just gold dust. After all, gold is priced purely because of its scarcity. Reinsurance is scarce but it is also very powerful as a leverage tool. If global premiums are now $250bn and the average rate on line is 10 percent, then this equates to $2.5tn of notional cover.

And isn't that roughly the total value of the global bailouts that have been pledged this year?
So in 2009 reinsurance is more like golden kryptonite - a powerful form of stable finance at a time of great capital scarcity and instability.

And it is also worth pointing out that reinsurance is itself supporting an even larger and more essential industry. Primary insurance represents approximately one in every ten dollars spent in the global economy - the equivalent of circa $5tn a year. It is the oil in the global economy's engine, allowing consumers and businesses to transfer risk in their economic activities. Without reinsurance - and with the capital markets closed - chaos would ensue among insurers, which could have a systemic impact on the global economy. Wasn't this, in fact, one of the reasons why the Federal Reserve stepped in to prop up AIG last year?
So if the stability of reinsurance is a cause for celebration, why did IQ begin this article by warning about missed opportunities?

"Reinsurance has proven this year its advantages as a smart, alternative form of capital"

As we have noted, the capital markets are thawing, investment bankers are coming in from the cold and investors' appetites for financing risk are returning. Of course, the availability of "cheap money" - which propped up the decade's economic boom - may not return for many generations. But the scarcity of hedge capital is diminishing; and it is scarcity that ensures the café de Paris terrace can charge four times more for its citron presse than the Dog & Duck in Darlington can for a glass of lemonade.

Pricing is at the heart of this potential missed opportunity. If reinsurance is simply an undifferentiated form of capital, then it will always be priced at the lowest common denominator. But the past year has demonstrated its unique characteristics. It remains relatively stable at a time of great instability, it is powerful (leverage) and highly responsive (new quota share treaties and capital relief transactions, for example, to support growth this year).

For reinsurance brokers - the cheerleaders for this vast and stable pool of notional hedge capital - there is arguably an even greater opportunity that may go wanting. Like investment bankers, their role is to channel the buy-side (direct insurers) with the sell-side (reinsurers/their balance sheets). The difference is that a typical transaction for an investment banker tends to have at least an extra nought on the commission cheque. Brokers, in comparison, are cheap. If the reinsurance industry's common complaint is its frictional costs (reinsurance broking), then it should look at bankers' commissions for solace (as demonstrated by the recent anger - channelled by the WSJ - that investment bankers and their legal friends may make up to $1bn in fees from the convoluted AIG restructuring).

To become a successful reinsurance broker, you understand your clients' need and find pools of hedge capital to help. To become really successful, a broker needs to answer the killer question: "How can I help the sell side become better rewarded for risk assumed and help the buy side get more value from the hedge?"

2009 - with the capital markets running scared - was a great year for brokers to answer that question and for reinsurers to re-think how they price their highly valuable capacity which, arguably, they give away too cheaply.

The danger is that soon the bankers, and their markets, will be back and nothing will have changed. Time is running out...