A new paper from Milliman, a consultant to the insurance and financial services industries, discusses the ongoing transformation in and of the global reinsurance industry that alternative investment has created.
About 20 years ago, in the wake of Hurricane Andrew and the Northridge earthquake, catastrophe bonds caught on as a way for pension funds, sovereign wealth funds, and high net worth individuals to invest in the reinsurance market. In essence, the investors bet against a specifically defined event such as an earthquake of a certain degree of magnitude.
The risk is made tolerable for the bettors, that is, for the investors who buy the CAT bonds, in part due to the short maturity of these instruments, typically five years or less.
But the influx of money that Milliman has in mind goes beyond those instruments. It also includes private deals such as reinsurance sidecars, which came into fashion after 9/11.
Decline and then Rise Again
Interest in reinsurance waned as a consequence of fall-out from the GFC. Lehman Brothers defaulted on four bonds in each of which it had served as the counterparty on the bond’s collateral. This sent financial investors with exposure in this space scrambling, as Milliman puts it “to understand their investment portfolios and the inherent risks therein.” They came to understand that although they had thought this investment was uncorrelated with other financial assets, indeed that was part of the initial appeal (and surely the occurrence of an earthquake is uncorrelated with the risk of stock market price falls and the like!) they found that such instruments are highly correlated (as a matter of counter-party risk) in a tail event.
The financial engineers went back to the drawing board, improving the instruments involved, and interest revived around 2011. By the end of 2016, Milliman says, alternative capital in the catastrophe space consisted of around $76 billion, which breaks down as follows:
- Collateralized reinsurance $39 billion
- CAT bonds, $25 billion
- Sidecars $8 billion, and
- Industry loss warranties $4 billion.
As a proportion of the whole: alternative capital now represents roughly 13% of the available capital in global reinsurance.
All this new capital has driven catastrophe reinsurance prices down to historic low levels. This has meant that many reinsurers have diversified into other lines of business, underwriters have modified terms and conditions in the face of competitive pressure, and there has been a boon of merger and acquisition activity.
With regard to the modification of terms and conditions, the paper observes that over time the use of indemnity triggers on CAT bonds, as distinct from index or parametric triggers, has become more common. The sponsors prefer indemnity triggers as a way of avoiding “basis risk”: that is, avoiding the mismatch between a bond’s recoveries and the actual catastrophe losses. Since 2011 the percentage of bonds with indemnity triggers has increased from 30% to roughly 70%.
With regard to M&A: recent deal activity includes the acquisition of Montpelier by Endurance, a mixed stock and cash deal valued for $1.8 billion, announced in March 2015, completed at the end of that July. The stated rationale there was, as Milliman puts it, “to increase scale, broad distribution, gain scalability to Lloyd’s platform, and have access to a third-party capital insurance and reinsurance platform.”
Another such deal was the purchase of Partner Re by Exor, announced in August 2015, consummated the following March. This deal $6.9 billion deal required a lot of wooing – Exor improved the terms of its offer six times. Milliman’s paper comments that this was “an example of a merger initiated by investors that had identified the reinsurance market returns as an attractive opportunity relative to the yields available elsewhere.”
In the latter half of 2016, there were three major deals involving the Bermuda reinsurance market: Sompo Holding bought Endurance; Arch Capital bought AIG’s mortgage insurance arm; United Guaranty Corporation and Liberty Mutual together acquired Ironshare. The paper asks whether these deals “are the end of the road or a precursor to more activity?” and answers on behalf of “the market consensus” that the answer is the latter. “Indeed, no company likes to be the last one left on the shelf.”
With new structures, the white paper observes, come new perils. As entities diversify outside their core strengths, they run operational risks where they might be not-so-strong.
Over the last year, insurers looking to make use of the capital flowing into the industry have become especially interested in insuring cyber risks and automobile liability risk.