It has been cheap, plentiful, and available in a plethora of different forms to carriers, brokers, InsurTechs – as it has been in the broader economy.
In our sector, the key drivers of competitive advantage have been talent, access to distribution and underwriting expertise.
In a world of rapidly rising interest rates, risk-off private equity, surging inflation and a Schwarzenegger-strong dollar, capital is more important than it has been in a long time in the world economy, and also within our own sector.
Access to capital has become an existential question in InsurTech, where cash burn means that regular new infusions of capital are needed to keep businesses going. Public markets, SPACs and traditional venture equity have all become difficult to come by.
Even for insurance fee businesses, it has become a question for the first time since shortly after the financial crisis whether they will have access to attractively priced capital.
Relation’s recap was called off after its backer was unable to secure its reserve price. US MGA heavyweight K2 will face difficult choices around whether to pull the trigger on its own refinancing, given the downwards pressure on valuations that is now emerging market-wide.
London-headquartered broker BMS too will face tough trade-offs as it considers its options amidst locked up debt markets – as does CVC-backed April in France.
Access to capital is also an acute issue in cat.
There was a thesis in the mid-2010s that cat reinsurance pricing had been broken by the surge of ILS capital in 2012/23. Hard markets were now a thing of the past because, the theory went, there was a massive pool of fast-flowing capital that would prevent the formation of a supply-demand imbalance.
As such, the old paradigm of a major loss followed by a surge in pricing and a period of new capital formation and excess returns was outdated.
This has proven to be utterly wrong.
Nevertheless, it is becoming increasingly clear that the old industry paradigm is not functioning as it did in the past.
However, it is the other half of the mechanism that is broken. Pricing is going to move, terms are going to tighten, retentions are going to surge. But capital is largely unresponsive.
With some slight caveats, outside capital doesn’t want to come in. And there is reluctance from boards and management teams to work existing industry capital harder through a greater allocation to cat risk.
A historic capacity shortfall is coming in cat, most acutely so in US wind, as surging demand driven by inflationary pressures meets falling supply from traditional reinsurers, and an ILS market facing paralyzing capital lock-ups.
Right through the value chain – across MGAs, insurers, reinsurers and ILS funds – access to capital to support cat underwriting will become differentiating.
Private equity calls and management teams
As is typical post-loss, private equity houses with experience of the sector are making phonecalls and exploring the size of the opportunity.
However, interest is lukewarm. There is close to zero interest in exploring a Class of 2022 balance-sheet start-up with a focus in reinsurance.
Balance sheets are always hard for private equity because this part of the industry cannot deliver a cross-cycle 20% return, meaning they require adept timing. But right now, there is profound scepticism from capital around the ability to build a franchise within reinsurance that will be valued by investors, creating real exit risk around a typical equity investment.
Indeed, right now there are no management teams doing the rounds at private equity pitching cat-oriented or even multi-line reinsurance businesses. (Neither John Doucette’s high-net-worth-oriented start-up, nor Robert O’Connell’s monoline Cyber Re fit this category.)
There is some private equity interested in exploring the post-Ian opportunity, but “as a trade, not a business”.
The most likely entry point for this money is via short-term sidecars run by incumbent carriers with a better-than-market track record, with Ark and Ariel perhaps the template for this. These vehicles are also more likely to get off-the-ground when an existing backer of the underwriting business is willing to put capital behind the sidecar – as White Mountains will with Ark, and Pelican and JC Flowers with Ariel.
Sources have told this publication that the following private investors (laid out in alphabetical order) are exploring such investments: Aquiline, Bain, Blackstone, CVC, Elliott, Flexpoint Ford, KKR and Warburg Pincus. However, none is sure to write a cheque, as often private equity will explore an investment opportunity and ultimately pass.
Sponsors will look at these short-term opportunities outside of private equity funds, either through credit funds, or other pockets of money set aside for special situations.
The brokers have so little confidence in new capital formation elsewhere that they are seeking to address the capacity shortfalls themselves.
Guy Carpenter is engaged with private equity around the raise of a vehicle to support a 10% index of its cat treaty portfolio. Aon is also looking to build an additional 5% index capacity to support its existing Marilla facility, with backing from private equity.
Gallagher Re is also understood to be engaging with private equity to explore options to secure new capacity for clients.
Another gating factor for fundraising is the limited number of available, credible leaders – although some are having exploratory discussions.
Former Axa XL Re CEO Charles Cooper – who has run a top-15 reinsurer - has been holding meetings with private equity. Former RenaissanceRe and Aeolus executive Dave Eklund has generated a lot of noise by taking calls with a string of private equity firms. However, the respected retro underwriting exec does not have a business plan, and is not actively fundraising.
In these cases, the likelier business model is believed to be a funds-management structure given that it is easier to concertina down with this structure as conditions deteriorate.
While such structures reduce exit risk, the ILS market as a whole is under extreme stress.
Sources typically place estimates for locked-and-lost capital in the $10bn-$20bn range, with a bias towards the higher end of that range.
This leaves the sector with an extreme capital availability issue given the existing level of trapped capital.
ILS market sources have said that it may now be less of a question of who can raise incremental capital and how much, but to what degree ILS funds can retain their existing mandates. Multiple fund managers including Aeolus, AlphaCat, Credit Suisse Asset Management, Nephila and Securis were already shrinking pre-Ian, and this is likely to be exacerbated post-storm.
Four consequences of the capital deficit
With no new capital riding to the rescue, a few things are clear.
1. The cost of reinsurance will rise substantially, and it will become a less attractive tool to buyers to manage earnings volatility and capital than in recent years.
As the scale tilts in favour of buyers, sources cited expected rate rises of 30-70% for US wind excess-of-loss business, with a bias to the lower end of the range.
Alongside this major push on price, there will be a wholesale reset of retentions, with some major reinsurers including Swiss Re pushing for the doubling of retentions that have largely been frozen since 2006.
Cedants will also increasingly lose the ability to supplement their occurrence protection, with aggregate and quota share. Terms will also tighten across the board.
2. There will not be enough limit to clear the market regardless of where pricing lands.
After many years of losses, few reinsurers feel like they have the investor credibility to dial up their cat bet to chase the 25-30% returns many believe are achievable.
Even if that upside looks outsized based on a “normal” loss year, most reinsurer management teams lack comfort with the downside scenario.
All insurers will be losers from the changes in absolute terms – but there will be relative winners and losers
Particularly with huge uncertainty around the availability of their own outwards protection from retro markets, this suggests that the reinsurer strategy of choice will be to offer “less-for-more”. Here reinsurers will look to take on less net risk than they carried in 2022 for more premium.
All insurers will be losers from the changes in absolute terms – but there will be relative winners and losers.
As such, poorly performing insurers/MGAs, InsurTechs, monoline property reinsurance buyers and small companies without real leverage are going to face real pressure. The Floridian standalones will be the paradigm example of the unfavored buyer.
If the proffered limit is 10% short of what is required, not all clients will be 10% short of their target program.
3. Cat risk will be “downstreamed” through the value chain in a major way, forcing insurers to take a careful look at their risk tolerance.
Catastrophe risk in the US has been subsidized for years by cheap retro/ILS capacity and underpriced reinsurance.
This has given insurers the opportunity to construct a low-attaching outwards program with interlocking occurrence and aggregate covers that allows them to lock in a maximum cat loss, handing off most of the volatility to the reinsurance market.
Insurers will now be forced into difficult choices, with either the need to hold far more cat risk net while paying more for scaled-back outwards protection, or to drop substantial cat aggregate on the front end.
Balancing the investor imperative to curb volatility and the client/broker pressure to offer a full service proposition, insurers will be unable to please all constituencies.
4. If you have the freedom to do it 2023 is a year to take more cat risk.
Much success in underwriting reflects a willingness to embrace risk when others are afraid, stepping in to write lines of business or client bases that have taken heavy losses.
In certain areas, this kind of opportunistic post-loss ramp-up can be done with a high degree of confidence that it will generate a good return.
In cat, this is not the case. Results will always be heavily driven by random chance – “roll of the dice” risk. But while the chance remains that wind will blow or the earth will shake, portfolios in 2023 will be much better paid and more favorably constructed than in many years. Your upside is significantly higher, your downside scenario less severe.
If you believe catastrophe risk can be underwritten, 2023 is the year to do it. If not now, when?
Outstanding question
There is a crucial outstanding question for the industry that will take some time to answer.
This question is whether the fundraising landscape will change meaningfully once January 1 is in the books.
The industry has earned a reputation for over-promising and under-delivering when it comes to cat market conditions.
After January 1 it will at least become clear how stark the supply-demand imbalance is and how dramatically rates have moved. The degree of dislocation will be a matter of fact not speculation.
Those looking to raise capital to write reinsurance will at that point have clearer data points and a less compressed timeline to sell private equity and other investors on the opportunity.
Will that be enough to turn sentiment? It isn’t clear. Some believe the industry needs to post two to three years of attractive cat returns to rehabilitate itself.
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