The reinsurance market is operating in a new reality of abundant capacity from traditional and alternative sources, low interest rates and thinner reinsurance margins, driven by intense competition against shrinking demand for reinsurance cover, according to A.M. Best’s annual special report on the global reinsurance industry.

Indeed, many observers now believe that these changes are more structural than the cyclical ones that defined the reinsurance sector’s past evolution, said the Best’s special report, titled “It is Not Your Father’s Reinsurance Market Anymore – The New Reality.”

The report quoted Warren Buffett, Berkshire Hathaway chairman and CEO, who commented about the reinsurance sector at this year’s annual shareholders’ meeting. “It’s a business whose prospects have turned for the worse and there is not much we can do about it,” said Buffett, predicting that a decade from now will be very different from the one that has existed for the past 30 years.

“Historically, traditional reinsurance protection had been the primary source of capacity for cedents,” said the report. “That is clearly changing as primary companies are retaining more risk and are increasingly utilizing alternative markets for their risk management needs.”

“The new reality for the reinsurance market looks to be more of an industry where returns are less impressive and underwriting will have to become a larger contributor to profits and returns,” said A.M. Best Vice President Robert DeRose. “This will lead to more conservative risk selection, more diversification of product offerings, a wider geographic reach and conservative loss picks.”

The new reality also is altering the way reinsurance capacity enters in the market. New reinsurers have formed after major loss events, such as Hurricane Andrew in 1992; the 9/11 terrorist attacks, and in 2005 after Hurricanes Katrina, Rita and Wilma (KRW), the report said.

However, A.M. Best said: “The old playbook of private equity starting a traditional reinsurance company and then exiting via an IPO is becoming less attractive.”

These days, investors would prefer to put capital to work “for a relatively short period of time – typically one to three years – as opposed to creating new companies that require longer-term capital commitments with a less certain exit strategy,” the report continued.

Indeed, after the last group of reinsurers formed in 2005, there began to be a realization on the part of investors that “long-term permanent capital may not be the most efficient or profitable way to take advantage of the opportunity for re/insuring certain shorter-tail risks — hence the rise of third-party capital or alternative capital,” the report said.

Risk of Alternative Capital

“Alternative sources of capacity began to enter the market attracted by the increased reliability of risk models, diversification benefits and potential returns to investors,” the report said, noting that the low-yield environment that has existed since the 2008 financial crisis made these types of investments more attractive to investors.

“Lower interest rates have led to an increased inflow of alternative capital as investors look for uncorrelated ways to improve returns.”

The use of structures, such as sidecars, and insurance linked securities (ILS), allowed for a shorter-term investment of one to three years, and consequently a relatively quick entry into the market and exit from the market, said A.M. Best.

Reinsurers, such as Hannover Re, Swiss Re and Munich Re, originally led the use of alternative capacity, which was provided by pension funds, sovereign wealth funds and hedge funds, the report explained.

More recently, however, investors and users of alternative capacity “are bypassing the traditional reinsurer and transferring risk directly to the capital markets,” A.M. Best explained.

As a result of these trends, alternative capital accounts for about 18 percent of total dedicated capital in the global reinsurance market, compared with 8 percent in 2008, said the report, quoting statistics compiled by Guy Carpenter.

“As a result, competition for U.S. property catastrophe business has been fierce since third-party capital exploded into the market (starting in earnest around 2006). The pressure has since rippled to other classes and geographies as capacity is reallocated.”

Competitive Market

Further, the report indicated, the abundance of capital has created a situation where major losses fail to lead to rate hardening – an historic trademark of the market.

“A.M. Best expects that if there were to be a catastrophe sufficient to move pricing, with the capital market’s capacity and flexibility, the inflow of capacity could make any such opportunity very short-lived. However, the truth is in the details. If an event produces losses far different from modeled expectations, then the market may react differently.”

The ratings agency pointed to several examples of how rates have remained soft despite major losses. First there was 2011, when the industry experienced more than $110 billion in global insured losses, and then in 2012 Hurricane Sandy cost $20-25 billion in insured losses. In both years, the report continued, pricing barely increased.

Since 2012, property cat has continued declining in the double digits for every renewal season, the report said, noting that the global reinsurance rate-on-line is back to pre-9/11 and pre-KRW levels.

As yields remain at historic lows and rates continue to soften, “companies have had to shift from a property cat focus to a broader view of the market,” the report said. “Books of business are becoming more diversified, and deployment of capacity increasingly more challenging.”

The report said that reinsurers see the benefit of multiple distribution strategies. Given the fact that reinsurance pricing has declined in the double digits for each of the past three years, reinsurers have been “building or acquiring primary insurance capability,” seeking to get closer to the source of risk, the report added.

A.M. Best predicted that the M&A trend will continue. “Reinsurance companies understand the need to form larger, global, well-diversified operations with broad underwriting capabilities to assess rrisk and to serve as transformers of risk to the capital market,” the report affirmed.

“Recently announced deals by some of the best-known reinsurance companies in the market seem to reflect for attaining greater global scale and diversified product lines and distribution.”

With price declines, lower premiums as well as increasing commissions and competition, “the need for M&A is becoming clearer, and A.M. Best believes that consolidation will continue, particularly among smaller players in the market as acceptable returns become increasingly harder to achieve.”

The winners in the market will be those that are able “to walk away from bad business,” have the capital and expertise “to write new, more complex lines of business and provide the products and services that clients want in a global economy,” the report went on to say.

Other success factors cited by the report include the ability to manage the inflow of third-party capital to their own benefit and participate in the new era of consolidation without being left out.

DeRose said that A.M. Best is holding its outlook for the reinsurance sector at negative, citing the significant ongoing market challenges that will hinder the potential for positive rating actions over time and may translate into negative rating pressures.