No Class of 2023: Why Capital Sits on the Reinsurance Sidelines

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At an AM Best Reinsurance Briefing, Aditya Dutt, president of Aeolus Capital Management, and Carlos Wong-Fupuy, a senior director for AM Best, described a years-long effort to find adequate prices, without interruption from hurricanes and secondary hazards. In short, what Dutt called a “clean year” — a disaster-free period when investors could feel comfortable that prices had risen to levels consistent with profitability — hasn’t happened over the past five years.

In addition, with rising interest rates, capital cost threshold rates are also rising, they said, posing a second obstacle to capital inflows into the reinsurance market.

“Every year we have a catastrophe and the market says, ‘Prices should be 20 or 25 percent higher.’ Then we have another year of $100 billion in insured losses, the market says, ‘No, no. It’s another 25 percent, and so on and so forth.

“Here we are, five years later after ’17, continuing to go through a process of price discovery,” Dutt said.

“Until we agree on the price and an appropriate rate of return, it is difficult for investors, whether traditional or ILS investors, to commit because it is difficult to understand the underlying risk they are accepting. If it’s hard to understand the underlying risk they’re accepting, it’s hard to praise it.”

“If the industry is constantly changing and engaging in price discovery, it’s going to be a difficult process,” he said.

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Dutt compared the five-year price discovery struggle to previous hard markets – after 9/11, after Katrina, after Japan’s 2011 Tohoku earthquake. “Every year after those tragedies we happen to have a clean year. So every time investors were rewarded for entering the market. Each time they thought they had reached a price equilibrium.”

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“That has not been true for the past five years. Until we convince investors, which is very difficult to do, that we have reached price equilibrium, it is very difficult for capital to come back.”

The stress of natural disasters over several years “has not been caused by one major event. Even in years without a major event, the accumulation of medium or smaller events has translated into average claims in excess of $100 billion,” said Wong-Fupuy of AM Best.

“We have a segment that was generating ROEs according to our estimates [returns on equity] about four or five percent in a market where the cost of capital is at least twice as high. This in a context where we’ve increased economic uncertainty, worry about inflation and recession – that cost of capital will continue to rise,” he said.

Both Dutt and Wong-Fupuy noted that ILS investors have historically been drawn to real estate risk by another factor: sustained low interest rates.

“We could argue that the problem prior to 2017 was that investors had no alternative investment options and that was why we had a thriving ILS market,” said Wong-Fupuy. “Now the situation is different,” he said, referring to the consequences of rising interest rates and an increased perception of risk. The “risk premium, which has increased significantly,” he said.

“As the cost of capital rises for everyone, including ourselves, we need to determine that the excess margin, or the margin we can get out of our product, is something that is sustainable,” said Dutt. “That is very difficult when you have an economic environment, an interest rate environment that is constantly moving and the perception that risk is constantly moving….

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“Until we do, capital will continue to be somewhat restrained towards this market. And I don’t think this is a six-month process or a 12-month process. I think this is a process of re-engaging with investors over a longer period of time about the merits of our asset class, which certainly exist,” said the leader of Aeolus Capital Management.

Wong-Fupuy noted several times that despite major cat events over the past five years, AM Best considers the market to be well capitalized. “It hasn’t gotten to the point where we can talk about significant erosion of capital,” he said, differentiating the strength of today’s reinsurance market from the conditions prevailing during periods of significant startup activity, when capital dented.

“One of the points we’ve made lately is the difference between the availability of capital and the way that capital is actually deployed. There is a lot of caution about how the capital is actually allocated, but we think there are still significant amounts of capital on the sidelines.”

Wong-Fupuy said the reinsurance market is well capitalized while acknowledging there is a temporary drop in capital due to unrealized investment losses. “There is no pressure on liquidity. Hopefully things will recover. There has been no rating pressure,” he said.

“Even well-capitalized companies have moved away from real estate cats, moved away from reinsurance and tried to develop their primary sectors more. It is very difficult to find an exclusive property cat reinsurer these days. That is something that has changed.”

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Responding directly to the question of whether there would be a “Class of 2023” posed by moderator and AM Best Managing Director Anthony Diodato, Wong-Fupuy said: “We’re seeing a lot of interest from management teams in new projects. There’s certainly a lot of discussion about that But that investor caution is still there.”

With 1/1 innovations in the rearview mirror, AM Best expects “some further rate increases, [tougher] conditions for the rest of the year—[and] we will see some new capital emerge. But experience tells us that it is very unlikely to become a capital flow, as we have seen in previous cycles. Most likely it will become something very specific and much more diversified than being exclusively a real estate cat company,” he concluded.

Later in the briefing, he returned to the question of when capital could jump off the sidelines, recalling AM Best’s response from last summer: “Before we see new capital actually entering the market convincingly, we need a few years of stable , strong profits.”

Wong-Fupuy said: “Since companies have tried to rebalance their portfolios, re-insure risk, move away from real estate capitalization, we started to see that [in] somehow that translated into better profits. Guess what? We had Ian. And things have certainly changed.

“All in all, the results look a bit better than in previous years, but we are not there yet. It will take time… We’ve seen all these price increases, but let’s see how the year goes and if that’s enough,” he said.

This article was first published in Insurance Journal’s sister publication, Carrier Management.

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