The World Cup was fantastic and surpassed all expectations. It is a shame that England could not also have surpassed expectations. Amidst all the coverage of the event, there was one interesting article in the press, which did not cover the usual ground of match reports, injury updates and post-mortems of England’s or Brazil’s performance – it was an article on how hedge funds are investing in the football sector and will continue to do so. The interest generated by the World Cup is only likely to whet the appetite of such investors even further.
The same (investment by hedge funds and other institutional investors) can also be said about the insurance market. Indeed, hedge funds, pension funds, sovereign wealth funds, private equity firms and other institutional investors have invested in the insurance market for a while, in particular the reinsurance market. This investment of so-called alternative capital has typically been channelled into the market through the use of cat bonds, sidecars, collateralised reinsurance products and other insurance linked securities (ILS). In some cases, the investors have invested directly into a (re)insurer.
There has been an emergence over the past few years, and a spike in the recent past, of hedge fund backed reinsurers. These reinsurers tend to target low-volatility underwriting business (which is different from the higher-volatility business usually targeted by ILS products although in time and with the benefit of appropriate risk modelling, ILS products may end up targeting non-cat perils). Such reinsurers will typically be sponsored by an asset manager who will manage the investments and who will have access to a free ‘float’ (i.e. the premium income) which can then be invested in accordance with the asset manager’s investment strategy (subject, of course, to any relevant restrictions on, for instance, what assets can be invested in for regulatory capital purposes). These asset managers will also have access to more permanent capital in that the reinsurer will be a regulated entity with certain capital requirements.
In each of these cases, the institutional investors are attracted by the ability to invest in risks which are uncorrelated to the financial markets, it allows them to diversify their investment portfolios, to establish a more tax-efficient platform to manage assets, and to potentially earn better returns than they would otherwise do if they were to invest in more traditional asset classes.
The amount of capital from these sources which has come into the market is pretty staggering, and with the level of returns some investors have seen and the continued low interest rate environment, it is likely that the level of investment will increase yet further. According to a report from Goldman Sachs published a year or so ago, assets invested in reinsurance by non-industry investors have grown over the past few years by over 800% to around US$45 billion. That is impressive growth by any standards. What is more, Goldman Sachs recently commented that the influx of capital from the capital markets into the reinsurance market could almost double to US$87 billion within the next five years without the need for new investment or proportionate allocations.
A great deal of debate has centred around the impact of this alternative capital on, in particular, the traditional reinsurance market.
There is no doubt that the influx of this capital has resulted in a growing convergence of the insurance and capital markets. The alternative capital providers are making available products which effectively package insurance risk (in the same way as other risks such as credit and foreign-exchange risk have been packaged) and allow it to be sold to capital market investors. Indeed, as noted above, in some cases these providers are adopting a familiar reinsurer model (albeit with a more aggressive investment strategy). There is also some convergence on the part of the traditional reinsurers and a sense amongst some of them that “if you can’t beat ‘em, then join ‘em”. A number of traditional reinsurers have, as a result, developed new investment structures to attract and manage third-party capital. This has generated a new income stream for them, as well as possible access to risks which they did not have the capacity to underwrite on their own and the ability to potentially cherry-pick the best risks for themselves.
This new capital is putting downwards pressure on pricing as the providers of this capital can benefit from having a cheaper cost of capital (not least because in many cases they are not rated). This has the consequence of taking the edge off the insurance cycle and smoothing some of the peaks of the pricing cycles. It would be premature to announce the death of the insurance cycle (no doubt to the relief of some players in the market) but it may be that, in certain business lines at least, the cycle may become less pronounced over time.
This alternative capital can be seen, and is seen by some, as a threat to the traditional reinsurance market. Indeed, some in the market have commented that there could be a mismatch between the risk being underwritten and the capital backing it in that the focus of the new providers is on returns and they may not necessarily be exercising sufficient underwriting discipline, and may not be ensuring that risk is properly assessed, priced and supervised.
However, there is an opportunity to be grasped here. This capital could be used to support new products covering emerging risks as well as to support the growth of emerging economies. The traditional market needs to make the case for this. In the meantime, what the traditional players do have is deep pools of underwriting expertise and this does set them apart from the alternative capital providers. In whatever form the alternative capital providers structure their investments, they will require underwriting expertise and this can be and is being provided in a number of cases by the traditional players.
If this alternative capital is in for the long term, and if products backed by such capital increasingly have the same structural features and terms as more traditional products, is there any mileage left in still labelling this capital as alternative? It is probably fair to say that the new capital providers have owners with different return expectations which could, in turn, drive a different (possibly shorter-term) strategy in some cases, although this remains to be seen. We are probably not there yet, but it would appear that we are heading in a direction of travel where the actual source of the capital may become less of a differentiating factor over time.
Martin focuses on mergers and acquisitions (both private and public), joint ventures, and corporate finance, principally in the insurance sector. Ranked as a key individual for corporate insurance by Chambers UK, Martin is "very good and knows his stuff" notes Legal 500. He has been praised in previous editions for his "quiet, effective, good-humoured mastery of deals and detail" and his “user-friendly, get-things-done” approach. Martin has also been recognised as one of the world's leading insurance lawyers by The International Who's Who of Insurance & Reinsurance Lawyers 2014.
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