The Rise of Alternative Capital

A new Insurance Information Institute white paper examines the impact of alternative capital on reinsurance, says I.I.I. chief actuary and paper co-author Jim Lynch.

What sounds like a dry topic actually may in the long run significantly affect the entire insurance industry, right down to the humble buyer of a homeowners policy.

It’s a dry phrase, so let’s parse the phrase alternative capital on reinsurance by starting at its back end. Reinsurance is the insurance that insurance companies buy. Insurance companies accept risk with every policy. They work hard to ensure they don’t have too much risk in one area, like too many homes along Florida’s Atlantic coast.

When they do, they protect themselves by buying reinsurance. Instead of buying a policy that covers one risk, the insurance company enters into a treaty that can cover thousands in case of a catastrophe like a hurricane.

Catastrophes are a big deal for lines of business like homeowners. More than 30 percent of homeowners claim payments over a 17-year stretch came from catastrophes, according to a recent Insurance Research Council study, and many of those claims were paid by money that ultimately came from reinsurers.

Legally, the insurance company is obligated to pay all claims, regardless of any reinsurance it has. After Hurricane Awful, a homeowner files a claim with his or her insurer, and that insurer is responsible for payment, regardless of any reinsurance it may have purchased.

While reinsurance doesn’t affect the insurer’s obligations, the financial health of the insurer depends on the quality of its reinsurance arrangements. Insurance companies are careful to spread risk across many reinsurance companies, so the plight of one will not devastate their own affairs.

To the average person, a traditional reinsurance company looks a lot like an insurance company, run by professionals who underwrite risk and administer claims. The pool of money to cover extraordinary losses — capital — had been built from contributions by an original set of investors and augmented by earnings retained over decades.

Here’s where the word alternative comes in. The new arrangements feature two twists on traditional reinsurance.

First, the capital to protect against big losses doesn’t come from within the reinsurance company. It comes from outside investors like hedge funds, pensions and sovereign wealth funds.

Second, the reinsurance doesn’t sit within the confines of the traditional reinsurance company. Companies called collateralized reinsurers and sidecars let investors pop in and out of the reinsurance world relatively quickly. Some reinsurance is placed in the financial markets through structures known as catastrophe bonds.

The new investors don’t use the traditional structure, but they do use traditional tools. Most ally with traditional reinsurers to tap those companies’ underwriting acumen, and they use sophisticated models to price risks, just as reinsurers do. Deals are structured so to be as safe as placing a treaty with a traditional reinsurer.

Such deals have grown; their share of global reinsurance capital has doubled since the end of 2010, according to Aon Benfield Analytics.

The amount of capital in the reinsurance market drives prices in classic supply-demand fashion. As capital grows, reinsurance prices fall, and alternative capital has driven reinsurance rates lower, particularly for catastrophe reinsurance.

If insurers pay less for reinsurance, they pass along the savings to customers. Citizens Property Insurance, Florida’s largest homeowners writer, reduced rates 3.7 percent last year, in part because of lower reinsurance costs.

If, as some experts argue, alternative capital is the new normal, consumers will continue to benefit from lower rates. If, as others contend, it is akin to an investment fad, rates could creep higher as the fad recedes.

The I.I.I. white paper looks at the types of alternative capital, its growth and its future.

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