Insurance only works if reinsurance works, those in the business say. An insurer that would face crippling losses if, say, a hurricane struck an island where it had covered lots of property against extreme weather, would typically insure itself against such an event with a reinsurer. But the $425 billion industry is under threat as insurers increasingly offload risk directly to capital markets instead. This month Warren Buffett, who has investments in reinsurance, dismissed it as a “fashionable asset class” whose prospects have “turned for the worse.”
Two things have made life more difficult for reinsurers. First, as insurance companies merge into fewer, global players, the share of policies they seek to reinsure has declined rapidly over the past decade, says James McPherson of PwC, a consultancy. A Slovenian insurer that used to take out reinsurance against a big snowstorm, for example, no longer needs to do so if it is part of a global insurance firm that can offset the risk with unrelated policies in other parts of its portfolio. Technological advances and regulatory pressures have also made insurers better at understanding and controlling the risks on their books.
Second, there is now far more competition in the industry, as hedge funds and pension funds muscle in on reinsurers’ turf. The most well-known way to invest is via “catastrophe bonds” issued by insurance firms, which pay regular interest unless a specified disaster occurs, in which case the issuer gets to keep the principal and use it to pay claims. Last year a record $8 billion of cat bonds were issued. Around $65 billion of “alternative” capital has now been pumped into the sector (see chart); Aon Benfield, a broker, expects that to reach $150 billion by 2018.
Investors are attracted by tax breaks, the relatively high yields on offer, and the fact that returns are uncorrelated with other assets (Wall Street and the weather do not usually have much to do with one another). In a sign of the times BlackRock, an asset manager, and ACE, an insurer, have bypassed reinsurers altogether in a new joint venture.
Several reinsurers are working with the new money to offload some of their own risks: Everest Re issued around $1 billion of cat bonds last year, for example, while Hannover Re agreed €3 billion ($3.3 billion) of “collateralized reinsurance” deals, which are simpler, smaller cousins of cat bonds.
Yet the new competition makes it harder for reinsurers to raise premiums. In the aftermath of hurricane Katrina in 2005, some reinsurers put their prices up by as much as 50-100%. In contrast, the string of expensive disasters in 2011, including the Tohoku earthquake and tsunami in Japan and the Christchurch earthquake in New Zealand, did not lead to a rise in market-wide premiums, despite costing the insurance industry $116 billion, much of it reinsured. Catastrophe reinsurance prices have fallen in seven of the past ten years. Willis, a broker, says that the price for protection against disasters — normally the highest-margin part of the business — fell by 10% last year on a like-for-like basis.
Some see the repackaging of risk in nifty new financial instruments as worryingly similar to the financial engineering that helped precipitate the credit crunch. In a new book, Paula Jarzabkowski of Cass Business School and her colleagues worry that ill-informed investors may be taking on risks they do not understand, and that the flow of capital could easily dry up if they suffer unexpected losses. Regulators fear that price wars might lead both conventional reinsurers and the upstarts to take on more risk than is prudent. The various alternative instruments remain largely untested, points out Brian Schneider of Fitch, a rating agency.
Distributing risk more widely, others retort, is no bad thing, particularly as the industry consolidates into a few global firms. Supporters also point out that there is a natural limit on the growth of the market. Issuers of cat bonds only benefit in the event of an (inherently rare) natural disaster: that means there is little incentive for speculators to sell cat bonds as well as buy them. And cheaper reinsurance should cut the price of insurance for consumers too.
That may have consequences beyond the rich world. The developing world remains lamentably underinsured. Less than 1% of the estimated damage from the recent earthquakes in Nepal, for instance, was covered by an insurance policy, compared to 80% in the Christchurch earthquake, according to Swiss Re, a reinsurer. The more capital available for reinsurance, the faster the insurance market can grow in such places. Rather than fighting over crowded and shrinking markets in America and Europe, reinsurers would be wise to broaden their horizons — provided the pension funds don’t get there first.
© The Economist Newspaper Limited, London (May 30, 2015)