With increasing convergence of the reinsurance and capital markets – both highly volatile – what can a reinsurer do to anticipate the future and manage capital markets risk for long-term success?

Reinsurance has always been an integral part of the capital markets. Reinsurers look to the capital markets for raising capital and assume investment risk through the purchase of securities. Increasingly, reinsurers are working alongside the capital markets to offer investors new risk transfer products. Likewise, many capital markets participants are now active in the reinsurance market, either as founding investors in new start-ups, providers of capital in sidecars or purchasers of insurance-linked securities (ILS). There is no doubt that this convergence is set to increase in the future. A successful reinsurer must be ready to capitalize on opportunities that emerge from this trend by being fully equipped to offer cedants risk transfer solutions in whatever form they choose.

The primary drivers for reinsurers to take on more capital markets risk are greater diversification combined with the prospect of more attractive returns. There is an increasingly unbalanced portfolio within the reinsurance market: catastrophe and casualty business continue to grow at a relatively rapid rate, but most other segments of the market have experienced little or no growth. As the primary insurance industry consolidates and the participants get larger and stronger, they will continue to cede less risk into the reinsurance marketplace. Reinsurers looking for diversification find capital markets risks attractive as they offer the benefits of low correlation with the reinsurance portfolio, combined with good return opportunities.

Of course, capital markets risks also have the potential for significant losses. As with insurance risk, a successful strategy of capital markets risk assumption must be executed within a rigorous risk management framework, using in-house valuation capabilities. The recent credit crisis caused by sub-prime mortgage losses in the U.S. highlights the importance of this, as an overreliance on third parties for evaluation and modeling was an important contributing factor in creating the excessive positions that led to the meltdown. It also highlighted the fact that a business model that is dependent on continual market liquidity is potentially flawed. Now, more than ever, cedants and shareholders should be looking for reinsurers with strong balance sheets and the core skill of assuming risk, which lies in the evaluation, valuation and management of risks that are held, rather than in the packaging and selling-on of risk, which is unsustainable in the long term.

It is also important to recognize the potential aggregation of risks between the investment and reinsurance sides of the business. Following the collapse of Enron in 2001, many reinsurers suffered losses in their investment portfolios, in their credit and surety reinsurance portfolios and also in their directors and officers reinsurance portfolios. Good data management is critical because it enables the reinsurer to measure the accumulation and correlation of risks in the investment portfolio and the reinsurance portfolio. It is equally important never to overexpose the company’s balance sheet to any one risk or class of risk. The large destruction of insurance and reinsurance capacity due to capital markets losses in the equity bear market of 2001–2002, and the huge losses on asset-backed securities reported by banks and insurance companies in 2007 and 2008, are valuable lessons. As part of any good risk management framework, there should be self-imposed limits on capital markets risk, just as with any key risk. Reinsurers should not expose more capital than they can afford to lose while still retaining their financial strength. Next >