- Reinsurance capacity has tightened relative to demand so far in 2023, particularly in the Asia-Pacific region.
- With APAC insurers’ comparatively high reliance on reinsurance, its rising cost has made balance sheet optimization a higher priority for cedants.
- Against this backdrop, retrospective solutions are gaining in popularity, as cedants look to divest non-core or legacy liabilities.
- Nevertheless, such transactions can be initially complex and time-consuming. Cedants will benefit from working with a specialist advisor to find the right partner for them.
Prolonged challenges for APAC insurers
Renewals in 2023 revealed a strong emphasis on price and contract conditions across all areas and lines of business. Although reinsurers are still well-capitalized, rising interest rates have caused some to incur mark-to-market investment losses, leading to limitations on capital.
While the supply of capacity appeared adequate at renewals, there is a sense that supply dynamics will continue to be challenged into 2024, with no quick return to the historic oversupply. Although economic capital remains strong, globally, we have seen reinsurers take a more disciplined and cautious approach in deploying their capital. This, in turn, has led to a tightening of capacity relative to demand.
The drive by reinsurers to generate better returns on deployed capital will put pressure on cedants to pass on price increases to the primary market and enhance their risk management practices, not least because of the expectation that reinsurance market hardening will continue. While there are a number of factors that contribute towards this, the key point is the persistency of the underlying drivers.
The tightening supply of capital relative to demand could be particularly acute for APAC operators. One contributor to that supply/demand dynamic is inflation. While inflationary pressure across APAC was a less prominent topic compared to Europe or the US, the region was not entirely immune. Inflationary effects were seen in several countries following increases in food, energy and commodity prices. In addition, APAC is experiencing the weakening of local currencies, while disruptions to supply chains arising from the COVID19 pandemic have still not fully eased.
Furthermore, insurers in emerging markets in Asia have generally operated a highly leveraged insurance/reinsurance model – meaning there is generally a high reliance on reinsurance. This leads to a ‘multiplier effect’ where a small reduction in reinsurance supply leads to a material impact on an insurers’ results. In particular, proportional reinsurance has been the financial foundation of many carriers’ capital management strategies so any continued contraction of proportional reinsurance supply will be of concern.
These features, along with other headwinds, have contributed to continued rate increases in the reinsurance market, with price increases then reflected in the primary markets to an extent. Climate-related losses, for example, have resulted in outsized reinsurance losses in some markets, leading to reinsurers taking a conservative view of future trends and losses. This has led to the withdrawal of capacity (especially for higher frequency events), coupled with higher pricing.
Asia has been a major contributor to the global growth engine with recent inflationary pressure further intensifying growing business needs. Additionally, there are a number of factors in the APAC market that potentially push the demand for capital solutions and resources:
- GDP growth/economic recovery post-pandemic, boosting the demand for insurance
- Increased claims inflation, leading to pricing revisions and increased solvency and capital requirements
- Governmental and social pressure to address the protection gap (under-insurance)
- Macroeconomic issues such as exchange rate and capital market volatility
- Tightened monetary policies, climate risk, regulatory solvency and accounting regime changes
- Limitations on traditional capital, combined with higher costs of reinsurance and increasing retentions, which places pressure on solvency ratios and profit margins.
As companies seek to optimize performance, there will be a trade-off between growth, profitability and solvency. To better manage risk and capital, structured and customized solutions are gaining traction, with retrospective products increasing in popularity.
Retrospective solutions allow carriers to unlock reserve capital. This can lead to higher returns, as profit earned over the lifetime of a product (i.e., from inception to final settlement of ultimate claims) contracts faster than capital held over its lifetime. At a certain point, therefore, profit outstanding is small compared to meaningful capital requirements, so strategically it may be better to “cut off the tail” and release the capital for redeployment into more profitable opportunities.
Retrospective reinsurance also allows for potential exits of non-strategic classes of business, again freeing up capital to deploy elsewhere. This enables firms to focus on their core business strategies and to achieve a better balance between solvency and performance. Retrospective structures can be a cost-effective capital solution, especially as there are different market cycles for the “prospective” and “retrospective market” providers, that can be optimized for both existing and ongoing capital funding needs.
Capital recycling
Tougher economic and market conditions will keep pressure on margins and overall profitability, while the cost of capital remains high in the short to medium term. In Asia, developing regulation which focuses on reserve adequacy and capital allocation is also highlighting underperforming lines. This, in turn, is reshaping business strategies.
As regulators place greater pressure on carriers to strengthen reserves and the cost of financing capital goes up, capital-supporting reinsurance structures can be more cost-effective. This is particularly true of retrospective products in respect of incurred losses (e.g. a reserve quota share, aka Loss Portfolio Transfers) where there is no need to factor in the unearned risk and cat loadings inherent in prospective quota share arrangements. In practice, however, a combination of prospective and retrospective solutions is typically considered.
Consider the motor class of business, which dominates portfolios across APAC. Motor is a capital-intensive product that is often used to fuel growth in other lines of business via proportional treaties. The inclusion of retrospective structures (which invariably can be priced more keenly for the reasons mentioned above) within a company’s reinsurance program could make legacy business management a key component of the management toolkit.
In the US and Europe, retrospective solutions have become a standard approach for efficient capital management. Asian deals, however, tend to be more ad hoc and it will take time to educate key stakeholders to encourage buy-in. There are significant execution risks if any party to a deal is unclear on the processes and requirements. Regulators also need to have confidence in the approach. The path to placement can be complex and timelines can be long. Nonetheless, there appears to be growing interest in this kind of transaction from cedants across the region, in combination with the emergence of legacy acquirers and capital as potential strategic partners.
With rapidly rising financing costs, insurers are coming to the realization that it makes sense for them to actively manage their demand for capital. The divestment of non-core liabilities creates opportunities to lower operational spending and financing costs. Optimization of reserve capital is increasingly seen as another capital management lever that can be deployed to support return-on-equity (ROE) enhancement and create significant value for shareholders.
In the current environment, cedants are likely to weigh the benefits of retrospective solutions against retaining assets to avoid crystallizing unrealized investment losses. An additional question to consider is whether the yield on retained reserve assets will stay ahead of claims inflation – in order words, is it better to retain investment control, or minimize potential volatility by ceding to a third party?
As for the counterparties to such deals, there is wide variability in their risk appetite. This is dependent upon the line of business under consideration; the territorial scope of any deal and the bandwidth of the acquisition team. This latter point has become more pertinent in the wake of COVID19, as managements reassess their strategies.
Insurers looking to take advantage of a favorable rating environment, and release and/or reallocate capital to support their growth, should consider retrospective solutions as a vital addition to their capital management toolkit. And in doing so, they need to have confidence that they can find the correct acquirer – one not only with the appetite and ability to transact, but with the right partnership mindset.
This is where a broker can add considerable value. Cedants should consider those with a broad range of skillsets that can be deployed in support of their transaction (including actuarial, capital, accounting, claims and project management capabilities). In addition, they should look for brokers with a high rate of deal-flow, which demonstrates strong relationships with the market’s key legacy acquirers.
Gallagher Re statistics:
- Key Deals: 11 major transactions with USD4.5 billion of volume traded in the last 24 months
- Fully-Integrated: Part of Gallagher Re’s core offering, working closely with account managers and line of business experts
- Global Footprint: 50 professionals with centres of excellence in London, New York & Singapore
- Breadth of Services: Our multi-disciplined and stable team offers expertise spanning broking, consulting, actuarial, ILS, Capital Advisory and M&A advisory
