Creative Solutions in a Returns-Challenged World: Reinsurance
The subtitle of Balentine’s 2016 Capital Markets Forecast is Creative Solutions in a Returns-Challenged World. One of the creative solutions discussed is an investment to reinsurance within the Manager Skill building block. This piece will go into reinsurance in more depth.
What is Reinsurance?
Reinsurance is a risk transfer service for insurance companies. When insurance companies write enough policies to become concentrated in one area or they need to write more policies to keep the relationships they have, they will engage a reinsurance firm. The reinsurance firm provides capital in the case of losses in exchange for paying premiums. The reinsurance company will then raise money from the capital markets to share in premiums and risks. This balances the exposure and allows the firm to continue writing policies for the relationships they have made.
The Opportunity of Reinsurance
The common theme in the yield segment of our Manager Skill structure is taking advantage of the decoupling that is occurring with the legacy players in the market. This decoupling in reinsurance is between the large insurance companies and the partners from which they buy reinsurance. Historically, insurance companies would gather their book of policies and ask the large players to purchase a sizable portion of the book at a certain price. They would then go to the smaller players in the market, hedge funds for example, and ask them to purchase the rest at the same price and risk level.
What makes an allocation to this asset class compelling in the correct implementation today is the insurance companies are asking the large players to buy more of their book. They are then giving the smaller players less but at more risk and at a less favorable cost. As a result, hedge funds have pulled out of the reinsurance market, and the large reinsurers now seek sizable and stable partners in the capital markets to share in risk so they can expand alongside the insurance companies. This in turn offers investors in the capital markets the opportunity to supply capital to these partners and receive return from the insurance risk premium.
This access is the sustainable advantage over public markets reinsurance offers. While access to the balance sheet and cash flows of an insurance company can be gained through the public markets by purchasing listed shares of insurance companies, it comes with equity-like volatility and influence from business factors that affect a company. Reinsurance allows direct access to the insurance premium for investors.
Ways to Invest in Reinsurance
There are two ways to invest in reinsurance, both which are insurance linked securities (ILS): catastrophe bonds and quota shares.
A catastrophe bond, or cat bond for short, shares several characteristics with traditional bonds:
- The cat bond issuer receives the principal in return for regular payments made to the investor.
- These payments are made from the premiums collected from the underlying insurance contracts.
- The principal is invested in short-term treasury securities and held as a reserve against the insured risk in a trust account which is legally separate from the cat bond issuer.
Cat bonds do not come with imbedded credit risk, a differentiator from many traditional bonds. Cat bonds typically have three-year maturities. Upon maturity, the original principal less payouts from insured losses is returned to the investor. Cat bonds tend to be quite liquid but can be difficult to purchase on the secondary market given the high demand.
Cat bonds generally represent remote risk for the four peak perils (natural disasters that dominate the insurance market): US wind, California earthquake, Japan earthquake, and Europe windstorm. An investor typically experiences losses only after insurance deductibles, primary insurer losses, and reinsurer losses have been experienced.
The second type of ILS is quota shares. Quota shares are a form of privately negotiated ILS contracts between an investor and a reinsurer. A quota share essentially allows the investor to purchase the premiums and associated risk of a portion of the reinsurer’s business. Since it is a negotiated transaction, the makeup of that portion is very custom and varies depending on the transaction. There is the potential to access contracts that insure against a variety of risks beyond the four peak perils, which can increase the diversification. Unlike cat bonds, there is no established secondary market for quota shares given that no two are exactly the same. However, this illiquidity is tempered by the fact that they are typically one-year contracts.
One way to think of a quota share is directly providing required balance sheet capital and in return receiving a proportionate slice of the diversified reinsurance portfolio. The funds are still held in a legally separate and distinct trust account from the company so there is not associated credit risk. However, the reinsurer is able to write policies for a dollar amount that is a multiple of the quota share capital provided. This structural leverage leads to the collection of premiums from a larger number of policies.
Like cat bonds, the reinsurer is liable for the third tier of losses after deductibles and the primary insurance company. An investor in quota shares is earlier in the waterfall and takes on a higher level of risk. In addition to the supplemental protection provided by a more diversified pool of risks, investors are compensated with a higher return and are structurally protected from losses beyond their investment. The liability for losses that exceed the investment remain with the reinsurer.
What Makes Reinsurance Different?
The return of an insurance linked security is the premium received minus the losses incurred. These losses from events (e.g. earthquakes, plane crashes, tsunamis, tornados, etc.) are by nature uncorrelated with the interest rate environment and global growth.
While a large natural or manmade disaster may have a temporary impact on public markets, as seen with Japan in 2011 and the US after 9/11, drivers of return for stocks and bonds quickly revert to their long-term sources. This uncorrelated return stream makes reinsurance an ideal vehicle to meet the objectives of the Manager Skill building block and by extension our clients.
What Are Some Risks of Reinsurance?
Investing in reinsurance presents two risks: risk of loss and timing risk.
The risk of loss is straightforward yet complex to predict. Insurance linked securities lose value when the loss from insurance claims is greater than the premiums collected. Because the strengths of earthquakes, presence of tornadoes or terrorist attacks rarely give indication of their intentions ahead of time, the timing and magnitude of a loss are hard to pin down. Ranges are given based on historical patterns and past events, but like any appraisal of investment outcome, they involve a fair share of estimation.
When a 1 in 30, or 1 in 100 year event occurs, losses are taken across the insurance industry. It is at that time that insurance companies need protection the most and pay more for reinsurance.
This idea introduces our second risk: timing.
There is one event that is certain in the realm of reinsurance, and that is the increased cost of reinsurance after a large event. Many investors try to time reinsurance by being out of the market when there is a lack of events and pricing is soft and then piling in after an event and pricing is more favorable. The fault of this strategy is there could be many years of no events, forcing them to miss out of the steady stream of income insurance premiums produce. Moreover, when an event does occur, the first call reinsurance companies make is to the longstanding partners that have shown they will be there in good times and in bad. These partners typically receive the most favorable allocations.
An investor in reinsurance can neutralize timing risk in two ways:
- Look at an allocation to reinsurance as a strategic one, and do not try to be out of the market during quiet times.
- Commit to invest additional capital after a large event to make sure the reinsurance partners have the capital they need to write more policies. This additional capital will earn yield at a much higher rate, working to quickly offset the loss. This commitment can be seen as a litmus test for an investor’s understanding of reinsurance and the risks it entails.
The Return of Reinsurance
The return of reinsurance has three main benefits:
- It offers attractive returns in today’s environment
- It exhibits very low correlation to other asset classes
- The majority of return is yield
We see an allocation to reinsurance as a crucial step in finding return for our clients by taking intentional risks in the capital markets. In an environment where low returns are likely and yield is sparse, we believe reinsurance is one creative answer to these problems.
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