Insurance value chain: Blurred lines

The insurance value chain across different market participants is becoming increasingly blurry, in S&P Global Ratings’ view. The influx of alternative capital is no longer a cyclical phenomenon, and we believe it’s here to stay, which is causing a flight for relevancy within the overall reinsurance sector. In addition, developments in InsurTech are emerging at the same time as other technologies, which signals fundamental changes for insurers and intermediaries on the horizon.

Amid these changes, the elements of insurance that link together — to form what is known as the insurance value chain — are becoming less distinct. In fact, competitive fluidity could separate some participants from the pack, which ultimately points to better credit quality.

Related: How funding, innovation and collaboration changed insurance

Following alternative capital’s playbook

Reinsurers are increasingly expanding their primary writings and emulating alternative capital’s playbook. At the same time, barriers to entry are now lower because concerns on the part of cedents about conflicts of interest have abated in recent years. (A cedent is the party in an insurance contract who passes the financial obligation for certain potential losses to the insurer.) Reinsurers’ success so far has been limited: Profitability from their primary platforms have lagged their bread-and-butter reinsurance business. Therefore, di-worse-ification has actually made reinsurers more vulnerable take-over targets.

We don’t believe structural changes in the rapidly growing “convergence market” — the intersection of alternative capital and reinsurance markets — will displace the role of traditional reinsurance players. Rather, we view the relationship between alternative capital and traditional reinsurance to be symbiotic. Reinsurers have been active buyers of retrocession protection (reinsurance for reinsurance mostly backed by alternative capital), which served them well in 2017. We are not seeing a “Class of 2017” emerge as we saw in 2005, given the strength of reinsurance capital, aided somewhat by alternative capital and historically benign catastrophe activity.

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Playing offense

Traditional reinsurers are playing offense by building their own side-car vehicles and borrowing underwriting terms from the insurance-linked securities (ILS) market to compete with alternative capital. The advantage is that traditional reinsurers can maintain or even enhance their relationships with clients because they can use these vehicles for business that fall outside their risk appetite but are still attractive to capital markets. Cedents can get the best of both worlds by skipping the additional transactional costs associated with an ILS placement.

Further supporting this trend is that primary insurance writers are starting to experiment with creating vehicles for their own risk to compete with traditional reinsurers. Reinsurers have typically been the sponsors of such vehicles, but they may become victims of their own success as more insurers consider creating their own vehicles, like sidecars and hedge fund reinsurers.

We believe that the impact from alternative sources of capital and entry into the convergence market is less pronounced for primary companies than for reinsurers. Barriers to entry exist for alternative capital constituents in the primary market given the need to build infrastructure (underwriters and agents, for example). Likewise, insureds might be weary of alternative capital entrants given their lack of a track record for paying claims.

At the same time, the role of reinsurers seems to be evolving and may become less occupied by independent players. We have seen a wider net of buyers interested in acquiring reinsurance platforms — from Eastern buyers (such as Sompo) to non-insurance conglomerates (like EXOR) to global insurers. Historically, reinsurance business had been a loss leader for global insurers, leading to a number of reinsurance divestments in the late 1990s and early 2000s. Improved risk modeling and data analytics may make insurers reevaluate their historical stance when it comes to reinsurance.

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Transformation through InsurTech

InsurTech has the potential to transform an insurance company’s whole value chain. That said, in our view, it’s likely to take at least 10 years for disruption to manifest itself. As insurance is highly regulated and capital-intensive, with high barriers to entry, we regard InsurTech as complementary to insurers, rather than a substitute for insurers. Furthermore, technology giants may view insurance returns on investment to be less attractive, which may make insurance a less compelling industry to disrupt.

Further clouding the traditional boundaries is that some brokers are creating form-following facilities and increased data analytics that compete directly with reinsurers. In our view, insurers are partly to blame, given that they aren’t being innovative enough, at times, in opening the pathway for brokers to develop solutions that attempt to solve client problems, particularly coverage gaps and underinsured risks. We don’t believe traditional reinsurers are being displaced, yet we can see competing brokers retaliate against facility participants in the form of lower submission levels.

Ultimately, a blurry value chain is not a shorter chain. Disintermediation creates more efficient supply-and-demand dynamics. It forces participants to up their game and provides a more stable source of capital offerings to meet evolving insurance needs.

Related: FEMA is exploring expansion of its reinsurance program

Tracy Dolin-Benguigui (tracy.dolin@spglobal.com) is a director and P/C Insurance Sector Lead in the North American Practice of S&P Global Ratings.