Retro uncertainty: Buyers face difficult trapping and terms decisions
Retro tactics are going to be a major driver of the outcome of 2021 reinsurance renewals, along with other key worries, such as low investment yields and casualty reserving adequacy.
But with pandemic lockdowns making for more than usual levels of opacity in the market and final fundraising efforts still underway, there is little sense of clarity over how the renewal will play out – other than that it will be messy, dislocated and pricey for buyers.
However, sources have highlighted several diverging tactics that retro buyers will be weighing up in the months to come, including:
how much basis risk to accept as terms and conditions tighten, versus the cost of more straightforward price hikes;
how much security to retain and how many battles to fight over Covid coverage, versus rolling and renewing cover for 2021
Rate and terms: balancing act
Effective retro rates are going to rise by more than underlying reinsurance rates, sources agree. One suggested it would outpace the average mid-year uptick, moving up by 15%-20%.
But others suggested that much of the higher yield might come from risk adjustments and changing terms and conditions – shifting to occurrence covers instead of aggregate, lifting attachment points, narrowing to specific named perils and geographies.
There is a relatively inflexible ceiling on rates as retro cedants will just not buy much cover above 30%-40% rates-on-line. "Buyers will just buy less – rates can't go up by 25% to 50%," one source said.
Tightening terms is still good news for risk-takers as it will provide a cleaner product – but if it does not result in maximum yields rising on an absolute basis, it begs the question of whether maximum returns will be enough to attract more opportunistic capital to replace the levels of trapped retro. (Although arguably no one should be advertising loss-free returns anyway).
That said, with few pension fund investors seeking these kind of tactical, timing-led decisions within their ILS portfolios, the pool of capital interested in this kind of sales pitch would always have been a small one.
If retro buyers or writers do manage to bring in opportunistic private equity risk takers for 2021, to what extent can the market rely on it remaining interested for the mid-term? One underwriter argued that it would be a risky strategy to build growth based on such price-sensitive retro capital, as if it evaporates, relationships might have to be unwound in following renewals.
There was also debate over where current retro market conditions position risk-takers relative to historic levels. Some suggested returns were more akin to 2013, and that renewals could take the market back to the 2011 conditions before the growth of Catco boosted the supply of aggregate worldwide covers.
Others suggested it was closing in on even harder historic markets in 1993 and 2002.
With narrower terms in place, reinsurers will inevitably wear more basis risk of a mismatch between their liabilities and retro protection – even if they are still buying indemnity cover, more specific geographic restrictions or peril coverages will mean they have to wear minor cat losses directly. But this takes the market "back to the way it was meant to be originally", one broker said.
Trapping vs protecting
Another factor that will heavily influence renewal rates is the results of trapping negotiations, which might lead to a wide range of outcomes.
One underwriter suggested that carriers that are willing to fully release retro capital could get away with single-digit renewal increases. This would move up to a steeper change for capital that is released subject to adverse development cover or clawback provisions, and higher again for those that trap capital outright.
As a backdrop to renewal negotiations, there is rising confidence that Covid-19 claims are not going to parallel the 2017 hurricane losses, particularly given the favourable legal verdicts for the industry to date. However, given the low level of reported losses to date, some further creep is still widely expected.
In light of this, the sceptical-minded might argue that trapping is as much about helping to stoke harder market conditions as it is ensuring security over capital and protecting against tail risk losses.
But ultimately, the decision might come down to how far carriers want to shore up this year's protection, versus hedging their hard market gains against catastrophe volatility in 2021.
"They will get a pass on bad results this year," one manager observed.
With rated carriers looking to offer more capacity on their own balance sheets, some in the market are clearly ready to take on greater volatility.
But overall, this will not close the gap left by retro trapping – estimated to be around 30% of ILS retro supply or more, which would be around $3bn-$5bn.
Meanwhile, as carriers compete with the major retro ILS funds to try scramble sources of third party capital, there are only small signs of gains so far in this field to date, with Hamilton Re setting up a new Ada Re vehicle of undisclosed size.
However, more is expected, so it will be a case of watching this space.