This has been a watershed year for the U.S. property/casualty market. The convergence of insurance/reinsurance and alternative capital has reached a tipping point and, for the first time, alternative capital is directly impacting market conditions for retail insurance. These investments are even moving beyond reinsurance.
In May, Marsh and Guy Carpenter created the first individual risk transaction involving the use of alternative capital at the insured level. This is a trend that will grow and evolve as investors continue to be attracted to investment returns that are not correlated with their portfolio balance. While this phenomenon is causing concern for reinsurers trying to figure out how to compete with this new capital and use it to their advantage, it is good news for buyers, as this investment activity has applied downward pressure to rates. At the same time, however, it is becoming a more complicated market. Going forward, buyers will need to understand the underlying market dynamics and build appropriate risk management strategies in order to be successful.
A Shifting Landscape
For the U.S. property/casualty industry, 2013 was a transitional year. It began in tumult as insurers and reinsurers tried to digest Superstorm Sandy. Those directly impacted by the storm sought to quantify their loss, while the rest of the market grappled with the unforeseen event’s impact on overall strategy. Prices across all segments of the commercial market were up by double digits in some regions. As the year progressed, the market settled down and rate increases began to dissipate. By year-end, increases had slowed to low single digits in most areas.
Based on history, we would expect this gradual softening to continue into 2014. Instead, market conditions softened much more rapidly than anticipated, led by catastrophe property rates that were dropping by double digits. This was due in large part to dramatic price decreases in the catastrophe property reinsurance market that began in July 2013. The softening gained momentum throughout the first half of 2014 and currently shows no signs of letting up.
Beyond the catastrophe property market, conditions in other lines are under pressure as well. At the start of the year, underwriters were looking for renewal rate increases that had been built into budgets. But these budgets were created in the fall of 2013 in a very different market environment. These efforts to increase rates were quickly thwarted as competitors cut rates to win new business, in part to fill holes in their budgets from the lower-than-expected rate environment. This spiral will continue as an increasing amount of capital chases a stable demand for coverage.
All of this activity suggests that the insurance landscape as a whole is changing. While the ebbs and flows of the property/casualty market cycle are nothing new, what has changed is the speed of course corrections in either direction. Multi-year hard- and soft-market cycles are being replaced by constantly transitioning markets that react quickly to results, both good and bad. The continued influx and acceptance of alternative capital solutions leads the change.
The Catastrophe Effect
While alternative capital is certainly impacting the market, it is by no means the only driver of current conditions. Last year was relatively benign for insured catastrophe losses worldwide. According to Swiss Re, there were about $45 billion of insured catastrophe losses globally, well below the 10-year inflation-adjusted average of $61 billion. What’s more, the North Atlantic hurricane season was essentially a non-event, producing only two named hurricanes, Ingrid and Humberto. This was the lowest number of hurricanes since 1982 and the sixth least active season since 1950. The season continued an eight-year stretch of relatively quiet North American hurricane activity-no major hurricane (category 3 or above) has made landfall in the United States since Katrina, Rita and Wilma in 2005. (While Sandy was devastating, it was a Category 2 storm when it made landfall in the Northeast.) This is the longest period without a major hurricane since 1860.
The market is of two minds in its reaction to the catastrophe lull. On one hand, the positive loss experience is bolstering investors who have been able to realize strong returns on catastrophe-driven securities. Demand continues to exceed supply, which is driving prices lower and disrupting the reinsurance market in particular. On the other hand, experts like Warren Buffett believe the market is too soft, particularly in high-risk areas like Florida. They are much more cautious, as we are clearly due for another big event. While no one will be surprised by a major hurricane hitting the United States, the real question is how it will impact the credibility of the catastrophe loss models that the market (both traditional and alternative) has become increasingly reliant upon.
The relatively low level of worldwide catastrophe losses in 2013 contributed to the strong results posted by the U.S. property/casualty industry. According to A.M. Best, net income for the industry grew more than 80% from the prior year to $70 billion. Beyond the favorable catastrophe loss experience, the industry benefited from strong results in all of its underlying components. As a result of positive rate movement in 2013, the U.S. industry posted a 96.2% calendar year combined ratio and 99.2% on an accident year basis. This was the first underwriting profit the industry generated since 2009. Investment income, while still low by historic standards, was up 2% over 2012. The industry continued to release prior year loss reserves, which totaled $16.4 billion in 2013. This represents a more than 10% increase in reserve releases from 2012. As a result of this strong performance, policyholder surplus grew by more than $60 billion.
Softening reinsurance prices also contributed to strong results. While U.S. commercial property/casualty rates continued to rise throughout 2013, reinsurance prices turned strongly negative by mid-year. According to Willis Re, prices for July 1 renewals dropped in most areas between 5% and 25%. These decreases continued through the end of the year. Nevertheless, A.M. Best noted that the reinsurance industry reported an accident year combined ratio of 94.7%. This contributed to a 63% increase in net income and a 17% increase in policyholder surplus.
Enter Alternative Capital
Although the reinsurance market had a good year, it is also the segment that is most vulnerable to the influx of alternative capital, which is why rates so quickly turned negative in 2013. According to Aon Benfield, non-traditional reinsurance contributes about 9% of the capital in the global reinsurance industry. Alternative capital has been a factor in the market since the mid-1990s, but it has become much more prevalent over the past five years. Improvements in modeling, diversity of offerings and lower frictional costs have made alternative capital more attractive to both investors and insurers/reinsurers. For insurers and reinsurers, securities can be structured that respond to a variety of triggers from their specific experience, industry experience, a parameter (like wind speed), a modeled portfolio or a combination of triggers. They can also purchase protection against specific perils (Florida windstorm, California earthquake) or a multi-peril basket. The protection can ultimately take the form of a sidecar, collateralized reinsurance, catastrophe bond or insurance-linked warranty. Likewise, an investor has multiple options from which to choose.
While this market has largely been focused on catastrophe property perils, it impacts the overall insurance market by pushing capital out of property reinsurance into other market segments searching for returns. As property rates continue to slide, reinsurers will move more aggressively into other segments in search of stronger rates and less competition, which will in turn drive pricing down in those areas. Ultimately, alternative capital is finding its way into other lines of insurance/reinsurance as structures evolve to offset historical challenges to building securities that efficiently transfer risk from longer-tail lines of coverage.
As previously mentioned, the alternative capital market participated in the first individual risk transaction in May 2014. The transaction for the Metropolitan Transit Authority was created in partnership between Marsh and Guy Carpenter and provided catastrophe coverage for windstorm, earthquake and flood as part of its May 1 property program renewal. As only a small group of very large insureds have a concentration of exposure, this may not become a common practice, but it represents a crossing of the Rubicon of sorts as the alternative capital market participates side by side with insurers and reinsurers on an individual placement.
The real question is how stable this alternative capital will be and how prevalent it will become in the marketplace. The market is growing rapidly. Between 2011 and 2013, insurance-linked securities assets under management grew 83%, but this still represents less than 1% of the total U.S. investment market. One study suggests that, if just 5% of the funds in the U.S. defined contribution pension market were invested in insurance-linked securities, the capital in the global reinsurance market would double.
The future of these securities and their acceptance depends on the accuracy of models moving forward. When the loss comes, will the models get it right and validate market pricing? If so, prices will adjust, but the market will continue to grow and develop. Rating agencies will become less cautious and investor confidence will continue to grow. If the models are wrong, the market will take a step back. If the models continue to evolve and improve as they have historically, the market will come back.
The benefit of the capital market involvement is that more resources will be focused on modeling and the models will improve more rapidly than they would otherwise. Either way, convergence of the capital and insurance markets will continue. The long-term impact will be shallower, more rapid market swings, as risk capital becomes increasingly fluid and models continue to more accurately price risk. Overall, industry pricing will also improve as more efficient alternative capital forces reinsurers to lower their expenses in order to compete.