Reinsurance companies have reaped the benefit of new investment from the likes of hedge funds, sovereign wealth funds, pension and mutual funds. These deals may be structured as catastrophe bonds, collateralized reinsurance and reinsurance sidecars, separating the investment from the rest of the capital supporting a reinsurer. "Alternative markets in the past 10 years have established themselves as an important supplement to the traditional reinsurance market, particularly in catastrophe reinsurance," says James Lynch, chief actuary, senior vice president of research and education, Insurance Information Institute. Most observers believe their presence has dampened rates. According to Brian Schneider, senior director, Fitch Ratings, as a result of recent large catastrophe events, there's been a decline in alternative capital in the insurance linked securities (ILS) space to $93 billion in June 2019, down from $98 billion at the end of 2018. Currently, he says, 15% of total global reinsurer capital is coming from alternative markets. Sam Friedman agrees. "Alternative capital, mostly in the form of insurance-linked securities such as catastrophe bonds, has provided additional capacity and has likely kept rates lower than they might have been had the traditional reinsurance market been the only provider," says Friedman, insurance research leader, Deloitte Center for Financial Services. Securitization of property-catastrophe risks has introduced an entirely new dynamic into the market, prompting insurers, reinsurers and brokers to compete and initiate or facilitate such offerings, Friedman explains. "In fact, 'alternative' might no longer be an appropriate designation. Securitization has become more of an accepted niche segment of the broader insurance and reinsurance markets." Eric Clapprood, principal and leader of the Capital and Risk practice in Insurance for Deloitte Consulting LLP, says alternative capital has led to more options, but not without consequences. "Regulators and rating agencies are more likely to conduct robust, look-through analysis of the balance sheets," he says. "Technology, awareness and general economic and business trends indicate that the number of reinsurance opportunities will continue to gradually increase, while the ability to execute deals at the right time will also improve, creating an execution agility that doesn't exist today," Clapprood adds. Insurers are rethinking what percentage of their business is based on risk-taking versus other avenues such as advisory, asset management and acting as a data owner (and insight provider). "This trend is further fueled by the long, low interest rate environment that makes profitable growth difficult for insurers." Over the past 10 years, there has been an estimated net increase in capital allocated to the reinsurance market by alternative "end investors," such as pension funds and sovereign funds, says Dan Brookman, head of Alternative Capital at AXA XL. This supply, together with growing capacity from traditional market reinsurers — in addition to relatively benign loss activity — has generally led to reductions in rates within property catastrophe reinsurance and retrocession. More recently, Brookman observes, the losses incurred by the reinsurance industry from events in 2017, 2018 and 2019 have affected the supply chain of capital from alternative investors. Market commentators have now started to refer to "investor fatigue" in some segments of the property catastrophe market. Brandan Holmes, vice president and senior credit officer for Moody's Investors Service, notes that alternative capital has increased significantly as a proportion of total reinsurance capital over the last 10 years, but especially since 2012. Because alternative capital is primarily focused on property-catastrophe risks, it has become a significant portion of capital available to support those risks.

No flight in sight

Lynch says there has been some hesitation in the past couple of years. First, some events proved difficult to model, pointing to Typhoon Jebi as an example. "Early estimates of the 2018 storm put losses at around $3 billion to $5 billion," he explains. "Now, estimates are approaching $15 billion." The other issue is trapped capital. "If a cat bond expires without being triggered, the funds are immediately available for investment elsewhere," Lynch says. "When the bond has been triggered, the capital is trapped in the original investment. So there is less money available to be rolled from investment to investment." Alternative capital was down for first nine months of 2019, says Schneider, but he expects it to rebound in 2020, depending on losses, primarily in Asia. The Asia renewals in April saw double-digit increases, given the losses from typhoons and flooding over the last few years. Friedman notes that, early on, there was speculation by legacy insurers about how significant disaster losses would likely drive speculative investors out of the alternative reinsurance market, but that hasn't materialized. "The number of cat bonds issued may be trending down this year," he says, "but it's only a mild decline." According to Clapprood, surprises in "modeling versus actuals" always cause temporary pauses in pricing and investment strategy. However, he believes that disaster trends will drive an increase in demand, which will be a larger driver of pricing flexibility and growth in the industry. "Natural disasters are also a subset of climate change studies that insurers are becoming more involved in researching, understanding and taking a lead with regard to finding mitigation and adaptation solutions," he adds. Modelers have disappointed with predictions, Schneider says. He points to Typhoon Jebi: The losses are actually three to four times the original estimates. It follows that investors are concerned about accuracy, which drives risk pricing. "Capital markets are willing to invest as long as the risk is understandable," he adds. "Some capital has decided to leave the market," Brookman observes, "due to downside losses in excess of what may have been 'expected' prior to making the investment." However, performance alone has not been the only driver, he notes. "The investor experience during the recent loss years has had a profound effect on the psyche of some investors, with respect to how their chosen ILS fund managers managed expectations during times of market uncertainty or loss." Some investors did not feel they were adequately "serviced" by incumbent ILS fund managers with respect to the explanation of risk exposures or timely estimates of where annual performance may end up, which generated a credibility hit within the ILS fund manager community. "The result has been a perceived 'flight to quality,' where some capital has been reallocated to other managers who were more proficient in reporting losses or estimating where ultimate loss results may end up," Brookman explains. "Generally, the more experienced alternative capital investors with a deeper understanding of catastrophe risk have remained in the market," Holmes says, "while some more recent entrants have reduced their exposure. Overall, our view is that alternative capital is now an established source of financing... There might be marginal fluctuations in the level of alternative capital capacity (but) we don't expect it to disappear from the market." Clapprood agrees, although he believes that alternative capital is creating a few trends. One is that with excess capital available, insurers are thinking through return on capital metrics and reassessing what products are profitable on a risk-adjusted basis. Another is infusing more talent and different thinking into the industry, including the enhancement of a more global approach to business strategy. "For example, assessing the correlation (or lack thereof) of insurance risks in the U.S. to those of other financial and operational risks and global insurance risks is more likely," he explains, "driven by more data and creating more opportunities than ever before." Both existing and new allocators are actively considering "alternative" lines of business to property catastrophe reinsurance or retrocession. "Specialty has certainly been one such line of business," Brookman notes. Given the prospect of broad-based rate increases for 2020, with rate increases expected across insurance, reinsurance and retrocession, some allocators are favoring strategies that provide broad exposure across the reinsurance market, rather than focused opportunistic strategies.

The effect on M&A

Friedman believes that the added funds from alternative capital vehicles could spur greater consolidation in the traditional reinsurance market. Clapprood adds that "Alternative capital will continue to generally provide more options for those seeking to optimize balance sheets while at the same time ramp up competition, so that those looking to make acquisitions and generate scale will find pricing more challenging." Brookman says that alternative capital has been cited as a key consideration for a number of recent acquisitions in which larger acquirers have chosen to acquire smaller targets. "The fee generation of alternative capital platforms has served to heighten the interest (and valuations) available from financial (and trade) buyers," he explains. "Over the past five years, there has been significant M&A in the reinsurance sector, driven by the need to build scale and gain efficiencies," Holmes says, "but also in some cases to acquire alternative capital management capabilities or platforms. A number of the smaller and midsize reinsurers have been merged with peers or purchased by larger groups. Although at a slower pace than in past years, we expect M&A in the sector to continue."

Parametric insurance

"Alternative capital itself was originally designed around parametric covers," Lynch says. "Only in recent years has it started to embrace other triggers. So the alternative capital folks have been moving a bit in the opposite direction. However, I think their activity has helped draw attention to parametric triggers elsewhere, as in micro-insurance and other insurance products." Given that many parametric insurance products on the market focus on catastrophe-related events, Friedman can see such alternative risk-transfer vehicles competing with catastrophe bonds, as well as serving as a template for the way alternative market vehicles are triggered by broad events, as opposed to specific claims. "We see alternative capital as correlated, somewhat, with enhanced technology and digital enablement," says Clapprood, noting a general increased pressure to improve expense ratios. He also sees a trend toward increasing consumer value for the personal lines business, and understanding the customer across the board. "This leads to a focus on how to communicate with customers and effectively deliver appropriately-priced products," he says. "As a result, parametric underwriting and similar capabilities that seek to balance time, risk and reward are expected to grow." Brookman believes the supply of alternative capital capacity for parametric opportunities currently outweighs the volume of transactions placed into the market by protection buyers. Alternative capital providers, as well as traditional reinsurers and brokers, have been motivators for addressing the "protection gap" within emerging markets, including via parametric instruments, he says. "It still feels like there is substantial room for growth in this market, once governments and other stakeholders become increasingly aware of parametric solutions and its benefits and are then willing to access such alternative capital capacity."

What's on the horizon?

"It will be interesting to see how the use of alternative capital expands over time," says Friedman. "Right now property-catastrophe is still the main attraction for capital market investors. Going forward, however, we could see a similar alternative risk-transfer approach take hold, for example, to spread mounting cyber risks." Brookman believes the natural tension between independent ILS fund managers and fund managers aligned with a traditional reinsurer will continue to play out over the coming years, as allocators seek to determine the optimal platform for accessing opportunities in reinsurance. The issue of ''trapped collateral'' remains a key concern for incumbent market participants, he explains. The absence of liquidity solutions for trapped collateral has exacerbated the debate of whether some asset allocators are willing to entertain strategies that have challenges in ultimate loss determination and finalization within a timely manner. Holmes expects alternative capital capacity to be reduced at Jan. 1, 2020, renewals. "This is likely to lead to further price increases for property-cat risk," he says, "and potentially capacity constraints in the market for property-cat retrocession during 2020." Schneider has observed one constant throughout the last decade: There is lots of capital and excess capacity. "Nothing has happened to wipe out capital," he says, noting that "this is a resilient industry." See also:

• The world's 20 largest reinsurance groups
• The reinsurers are coming
• Global insurance deals totaled $4.61 billion in September 2019
• Fitch Ratings releases 2020 outlook for global reinsurance sector