Is the most efficient reinsurance capital showing itself to the door?
Catastrophe reinsurance risk-takers are growing increasingly optimistic that, after several years of failed starts and relatively modest gains, the upcoming January renewals will bring them significantly improved return prospects.
Money that has been leaving the sector, much of it from the ILS space, is a key driver of this optimism over rate increases. A significant contribution also comes from rated carriers like Axa XL and Axis Re cutting back their portfolios to limit volatility.
Amidst this, one comment that I heard from an investor recently gave me pause to wonder whether the current situation will give rise to a market that while more rewarding for those who stick in is in some ways less efficient overall.
Among the investor’s reasons for considering scaling back in ILS was their belief that “this industry doesn’t need my money”. In some respects it clearly doesn’t, as returns have failed to improve due to consistently strong reloading after each disaster-struck year.
And yet, I wondered, why should he be the one to leave and let others benefit from rising yields – when in theory, his capital should be more efficient for peak risk than a reinsurer’s equity?
Both cedants and investors would ultimately benefit from generally stable prices that build in a solid margin for transferring cat risk. And while we haven’t yet seen a return of the wild swings of price volatility in the pre-Katrina era, the 2017-2022 period has undoubtedly been more bumpy and painful for both sides than was anticipated in the smoothly soft market of 2013-2015.
And yet it seems that the bulk of the pain of capital withdrawals that are effecting this transition to adequate cat pricing will fall on the ILS sector, when arguably reinsurer balance sheets were more bloated than they needed to be pre-pandemic and have only gained further heft since.
In theory then, which capital should show itself to the exit door first in order to drive more sustainable returns?
In terms of the industry’s ideal capital structure, a panellist’s comment at the recent Insurance Insider London Market Conference caught my attention as he described the industry’s ideal capital base as “there when you need them and not there when you don’t”.
The problem of course is that that ideal is somewhat oxymoronic. When you need to serve ongoing needs of reinsurance cedants, and want to maintain some stability in a portfolio, the cash cannot be both there and not there.
At the same time, this is the end goal of having an ILS market – enabling there to be a mix of permanent capital alongside facilities that can be drawn down or not as needed.
So on the one hand, maybe ILS investors leaving can be seen as an example of efficiency in action. The open-ended fund structure and ability to redeem is one of the issues that led ILS capital to compete as a cheaper source of capital... so therefore it makes sense investors depart if they don’t like returns, because they can.
This is not good for ILS managers of course, as they would prefer to have stable fee income, which is a reason some have moved to raise permanent equity or have longer lock-ins for investors.
Nor ultimately is it good for cedants if they lose out on a source of efficient capacity.
But perhaps the retraction of ILS capital also reflects a changing view on what makes efficient capital.
The retraction of ILS capital may also reflect a changing view on what makes efficient capital
While it was previously taken as orthodoxy that ILS capital was the most lean and efficient, in recent years the issues with “trapital” has led investors to revise up their cost of capital to reflect collateral drag. On the other side of the equation, cedants are now seeing rated paper as operationally more efficient – so the pendulum has swung back to recognising the efficiencies in that traditional model.
But maybe the bar has shifted too far – it wouldn’t make sense for the ultimate cedants, and ultimate investors to lose all the flexibility of ILS funds (although we are really talking here about who takes the pain of incremental capital departures here rather than a wholesale withdrawal).
Either way it highlights that there is recency bias in the industry as well as investors in this respect. Trapital has become a bigger pain point because of repeated minor losses, whereas if there had been one massive loss hit, maybe collateral wouldn’t be seen as inefficient but instead its credit security would be more highly valued.
In a theoretical alternative world, it might have been more efficient overall to have seen more use of rated capital buybacks or enlarged dividends – throughout the soft market if not now. Could that outcome have contributed to maintaining more stability in rates at a sustainable level, if 2017-2018 losses had not been so steep?
According to the Aon Reinsurance Aggregate, amplified by last year’s capital raising but also solid income in 2018, reinsurer equity grew 15% from year end 2018 to 2020.
Rather than end ILS investors concluding that their dollar is the problem here, it should be acknowledged that every capital dollar in the market is impacting the painfully slow remediation that has occurred since 2017.
Even though the ILS market has built a sizeable stake in the cat reinsurance industry, the balance could still have further to shift, scaling up the flexible side of the industry’s capital base and shaving some off the permanent side.
This might seem a counter-intuitive argument at a time when capital withdrawals on the ILS or quota share side are creating pain and more reliance on that permanence – but if there had been fewer steep losses in 2017-2018, then there wouldn’t now be the reaction we are seeing today.
Of course, such is the flexibility of the ILS market that it is still possible that their capital will be the one drawn-down to patch up expensive holes in programmes at the last minute this year.
But at this point it is a wait-and-see game.