Swiss Re Upbeat on Prospects for Alternative Capacity
Alternative capacity (AC) has made a big impact on the insurance and reinsurance sector in recent years (AC) and recorded strong growth. While AC capacity is not new to the reinsurance industry, its capacity has jumped to US$45bn (or 11% of the global property catastrophe market) in 2013 from US$25bn in 2010.
The biggest growth has come from collateralised reinsurance, which overtook catastrophe (cat) bonds as the most important source for AC, according to a recent report by Swiss Re. While the importance of industry loss warranties (ILWs) is declining, outstanding cat bonds stand at a record level this year.
Collateralised reinsurance transactions are privately structured contracts used to gain exposure to the traditional reinsurance market. The collateral can be anything contractually agreed including, for example, letters of credit (LCs).
Structuring costs are lower compared to insurance linked securities (ILS) since there is no tradable instrument to be issued. The transaction can be channeled through a non-rated special purpose reinsurance vehicle, because the collateral provides security to the cedant.
While structuring costs are lower, a liquid cat bond market with more market participants should lead to greater pricing efficiency. Collateralised reinsurance is not tradable and thus restricts the number of AC investors who can write it.
The Swiss Re reports that the current popularity of AC reflects attractive property cat rates and cheap capital, and the range of investors has also expanded to include more long-term oriented sources.
While AC is expected to stay in the market, the recent pace of growth – particularly that of collateralised reinsurance – is not expected to continue.
Lloyd’s of London and the smaller Bermuda-based reinsurers without product differentiation are at the highest risk of losing market share to AC since it is an opportunistic follower of the market, according to Swiss Re. By contrast, top-tier reinsurers are well positioned to compete successfully as strategic partners.
The report suggests that AC will continue to focus on markets with high margins and low entry barriers, such as the peak natural catastrophe risk segment, as it is uncompetitive with traditional reinsurance.
Additionally, AC is basically commodity capacity, whereas large, well-diversified reinsurers have more services to offer. Rising interest rates will boost returns on potentially competing assets classes, which may make AC investments relatively less attractive, according to the report.
At the same time, if reinsurance prices were to fall, this would cut the excess profits in the US property cat market, removing the fuel that currently attracts AC.
Of the various forms of AC, ILS have proven resilient and are likely to endure. They are more investor-friendly than other types of AC since they are more transparent because they are traded, rated and regulated, states the Swiss Re report.