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A new white paper from market intelligence company Morningstar claims that due to the increasingly volatile weather conditions – caused by global climate change – reinsurance has become an area prone to complications for institutional investors, including those insurers not deeply exposed to climate risk already, such as life and bulk annuity insurers, which have increased their appetite for alternative investment areas.
“Since the series of hurricanes in the 1990s, the reinsurance industry found its pricing power became one of arbitrage,” said Morningstar’s June Financial Services Observer. “Institutional investors became attracted to the industry because of its low correlation to the performance of financial markets and governments.”
It’s an issue that means reinsurers are having to make awkward choices about where to look for capital as well as how much to keep on hand. “Traditional reinsurers have been put in a tough spot up until the last couple of years,” said Henry Heathfield, Equity Analyst at Morningstar. “That's been due to a combination of factors: falling yields within fixed income markets and their balance sheets have been bloated. They’ve had more equity.”
“There’s been a situation where those alternative capital providers
have had yields that have fallen.”
This, he said, means a higher amount of capital within the industry, which has meant less pricing power for reinsurers. “There’s been a situation where those alternative capital providers have had yields that have fallen,” he added.
The issues have also seen the production of several potential solutions – such as, one, looking for returns that aren’t correlated to the market, and, two, trying to get returns to supply more capital into the reinsurance market and catastrophe (CAT) bonds.
Morningstar’s report focused on the path alternative capital have taken into the reinsurance world, and which areas were most attractive to institutional investors. “New catastrophe bond issuance rose from below $1 billion to over $8 billion in the years that followed. The percentage of global reinsurance capital it represented reached double digits 10 years ago,” the report noted.
However, the catch was the Morningstar’s research also found that capital won't necessarily generate a risk-adjusted return in the reinsurance industry, as global warming leads to economic losses.
The US spent $21.5 trillion on construction last year, it added, which Heathfield said was also concentrated heavily on the coasts where population growth and property value increases were most prevalent – all of which increased risks and complications. “This is staggering considering the $275 billion economic loss from natural catastrophes,” said the report.
It added that: “While insurers and reinsurers have helped close the protection gap across human-made and weather-related catastrophes over the last 50 years from 4.8 times to 2.3 times, there is a minimum $250 billion protection gap that remains outstanding. At current and reduced capacity, with temperatures and expenditure rising, that protection gap looks set to increase.”
“There's been a correlation with the rise in natural disasters around the world, and that's meant a rise in losses for the reinsurance and alternative capital.”
All these issues, ultimately affecting reinsurers' pockets, are also impacting the industry’s appeal with institutional investors.
“You've had the rising surface temperatures of the earth [and] with them there's been a strong correlation with the rise in natural disasters around the world, and that's meant a rise in losses for the reinsurance industry and the alternative capital industry,” continued Heathfield.
Heathfield said this era “kicked off” in 2017 when the Atlantic Hurricane season saw some of the biggest losses it had seen in decades and spooked markets with Hurricanes Irma, Maria, and Harvey. “You've had a situation where, because of that increase in supply and low yields, there was an increase in traditional supply and increase in alternative capital,” he said.
“There hasn't been a lot of pricing power for these traditional reinsurers. You then fast forward to a post-pandemic world where we have rising inflation and rising interest rates, and that means that fixed income values are falling, which means that traditional reinsurance capital supply has been reduced," he added.
As supply has slowed, there in turn seems to be less appetite for alternative capital coming into the industry, which has given traditional reinsurers more pricing power. “We've seen that over the last two years, reinsurers have increased their price by a fair amount."
“Alternatives are well suited to the reinsurance industry, particularly around
retrocession. That's how alternative capital came about.”
For instance, Heathfield said that Hannover Re increased natural catastrophe (nat CAT) prices by 30% in the January 1 renewals this year. “They had more with [to play with] in that reduction in capital supply, the reinsurers had more pricing power, then add on top another layer coming on is the IFRS17 accounting change,” he added.
Traditionally, liabilities have been discussed at market rates and that discount rate has stayed locked in, and now they are being discounted on an accounting basis, he said, as part of this change. “That should theoretically increase equity because they're adding another couple of layers with the risk adjuster.”
The new changes mean reporting against IFRS 17 will require insurers to transform their processes, controls, and technology, and prepare data at a new level of granularity. The contractual service margin, which is the present value of future profits, means these investors are getting a reduction in equity across reinsurance and, to a slightly lesser extent, insurance.
These issues raise the topic of how saturated with private equity money the industry was at the time of 2017 and whether that interest – always seen as a Fairweather investment – would stick around in the long term. “My view on this alternative capital is twofold: with the better rate environment there is less appetite for alternative capital,” said Heathfield, adding that alternative capital is currently used as an instrument and these instruments have less demand now.
“Alternatives are well suited to the reinsurance industry, particularly around retrocession. That's how alternative capital came about. They know what they're doing.”
“I'm not sure that relationship is going to go away; more than
anything, it is going to strengthen.”
He said that with these changes in the number and volatility of risks, the industry has increased massively.
“There’s so much potential loss scenario basis now, and reinsurers are well placed to partner with primary insurance markets and help them understand the risks that they're exposed to,” he said. “I'm not sure that relationship is going to go away and more than anything is going to strengthen.”
With the viability of reinsurance investment experiencing more turbulence, investment teams at insurance organisations should consider the pros and cons carefully before jumping in head first with allocation decisions.
