Insurers bet on reinsurance in unexpected U-turn

While the reinsurance landscape has undoubtedly changed in recent years, with new players gaining market share and the capital markets having a growing influence on pricing, the cost of capital and the way risk is distributed, few would have predicted its latest shift—that owning reinsurance operations would again appeal to large insurers.

Veterans of the industry know only too well that once upon a time almost every large insurer operated a reinsurance arm in some shape or form. It was seen in the 1980s and 1990s as a natural extension of an insurance portfolio—another basket of risk, offering diversification and, often, better pricing.

One by one, they exited this market after being stung by heavy losses. The volatility inherent in many types of reinsurance was deemed incompatible with the steady, predictable earnings demanded by shareholders in primary insurers. Many instead built up big books of life and health business and focused on lines with more manageable volatility.

The recent acquisitions—of XL Group by AXA and Validus by AIG—have demonstrated a fundamental change in the philosophy of large global insurers. They see reinsurance as attractive again—and this has big connotations for the industry going forward.

Yet more competition

“The most dramatic shift in the last few months has been the dynamic change in reinsurance mergers and acquisitions (M&A), with large primary carriers re-entering the reinsurance market, having largely abandoned the sector in the 1990s and early 2000s,” says James Kent, chief executive officer of Willis Re.

This represents yet another fundamental shift in the landscape for reinsurers, primarily because some of the world’s biggest financial services firms with very large balance sheets are willing to write this business again. This potentially adds a lot more competition into a market still coming to terms with how capacity from the capital markets can, and does, impact pricing.

On top of this, a clear motivation for both AIG and AXA was the access to alternative capacity and the capital markets will offer. As one executive who preferred not to be named said: “If I were a pure-play reinsurer right now, I would look at that increased competition and be very worried indeed.”

Mike Van Slooten, head of market analysis at Aon Benfield, agrees that this is a trend that could have fundamental consequences for the industry. He also acknowledges that it marks a complete U-turn from the strategy of the major players in the late 1990s and early 2000s.

Between around 2000 and 2003 a number of primary insurers divested their reinsurance operations. Travellers spun off St Paul Re, and AXA divested itself of AXA Re, to name but two such examples.

“At the turn of the century there was definitely a phase of insurers exiting the reinsurance business,” Van Slooten says. “At that time, the volatility from cat losses was something that leaders were struggling to explain and justify to shareholders; on top of that, the liability crisis of late 1990s was still having a negative effect on underwriting results. That just added to the pressure.

“In the context of the AXA and AIG deals, it certainly looks as though insurers are going back to wanting to own reinsurers,” he says. “AXA actually spent a long time disentangling itself from AXA Re, and now it is back in the reinsurance business thanks to the XL deal.

“Some 15 years later, after two deals in short succession, it does seem as if things are going the other way again. It is a cyclical industry in many ways and we have always seen patterns of behaviour repeating themselves. That said, a lot has changed in the past 15 years and the market has really moved on,” he says.

Others agree. “The assumption now is that access to diversified sources of risk, allied with greater confidence that historic technical issues are now better managed through advanced risk quantification techniques, is sufficiently enticing for large primary companies looking for growth.

“The ‘big balance sheet’ reinsurer model is being reinvigorated and the real test for management will be their portfolio management ability and the agile use of their large balance sheets,” says Kent

Times have changed

The implication has always been that some of these big carriers did not quite understand the reinsurance risks they were taking on—that their exposure management was poor, as was their understanding of risk accumulation. In the end, most decided to stick with what they were good at.

These recent deals suggest that all that has changed. Primary insurers are under pressure on many fronts—as technology revolutionises their distribution models, their margins are becoming tighter and the competition intense.

Growth is proving hard to find, and reinsurance has the potential to solve some of these challenges. It appears such businesses now have the confidence that they can better manage reinsurance risks. Risk models are certainly better these days.

Van Slooten explains that there have been two big changes which help explain the logic behind this U-turn. The first is the growing influence of alternative capital in the market. While this has mainly been felt on the reinsurance side of things, Van Slooten says, primary insurers are now increasingly recognising the benefits of having an understanding of this market and access to its capital.

The second change has been the more sophisticated understanding of risk that the industry has developed. “This means that reinsurers are now more efficiently run and have a much better handle on their exposures,” he says.

“Reinsurers are less likely to have any nasty surprises,” he adds. “Most reinsurers have been tested in the past 10 years thanks to the financial crisis and heavy cat losses, yet most franchises have been able to trade through all this and continue to grow.”

He says a big part of this achievement is the development of better risk models and better analytics and data.

“Back 20 years ago, there were a lot of unknowns and accumulations of risk were not understood. People did not always understand their true exposures; when the industry was tested back then, you used to see companies go into run-off. That does not happen now. Plus, insurers know that when there are no losses, they generate a lot of cash.”

There are other driving forces behind the recent M&A activity. Van Slooten says that regulation, and specifically the higher costs of compliance, are important factors as it is easier for larger companies to absorb these. That makes it tougher for smaller reinsurers to survive. “Scale is very much a factor now and bigger is more desirable for that reason,” he says.

He notes that the work done by many large insurers in terms of centralising and rationalising their reinsurance buying has achieved the same effect.

“They have a much better understanding of their books of business and the volatility. They know what they want to retain and what they want to get rid of—it comes down to the use of data and developing the portfolio they want,” he explains.

Van Slooten admits that a return to reinsurance has the potential to cause problems for insurers, especially if it does indeed make their earnings more volatile, and given that investors have been used to relatively smooth earnings for some time.

“That is where management teams are going to have to spend time explaining to shareholders exactly why they are doing this and how they will manage the downside risk,” he says.

“At the moment many mid-tier reinsurers are taking on a lot of volatility and not necessarily being paid for it because of the competition from alternative capital, which has depressed rates.

“Bigger companies with larger books of business can take that volatility and access financial markets as well—they have the option of taking what they want but also offsetting some risk.”

He believes XL will take a lot less peak risk now it is owned by AXA but in both instances, part of the motivation is the acquisition of expertise, knowledge and relationships in the alternative capital space. He predicts that the insurers will use these vehicles to lay off risk but may also channel some primary risks through third party vehicles in a way similar to how reinsurers have used sidecars for some time.

“Take AIG—it has a huge balance sheet and can retain a lot of risk. Now with a channel into the capital markets via AlphaCat, they can take on even more and leverage this access to the capital markets in a way they could not before. They can package risks and split off anything beyond their own risk appetite,” he says.

Is this just the start?

If these deals make such sense for AXA and AIG, will other insurers follow suit? It was strongly rumoured that Allianz was making a play for XL. If that is correct, and AXA won that particular contest, Allianz could return to the market in search of another reinsurer.

Van Slooten notes that many of the Japanese insurers are still hungry for deals to compensate for a lack of growth in their home market. Sompo acquired Endurance Specialty in 2016 for $6.3 billion, and Tokio Marine bought Houston Casualty for $7.5 billion.

Some of these have already said they would be open to more deals, and Dai-ichi Life, Japan’s second largest private sector life insurer, has long been rumoured to be about to make a move (but has yet to do so).

There could be other drivers. January’s US tax changes will improve the competitive position of US insurers and Solvency II has made European players explore their own strategic options.

“We will see more deals follow these. There is something of a herd mentality but they are also fishing in a shrinking pond. There are only so many franchises left and that will concentrate minds,” Van Slooten says.

Kent at Willis adds: “Many major non-life primary companies with large personal line and small-to-medium enterprises portfolios are facing the greatest disruption from new distribution models. Similarly, large primary companies with life portfolios are facing profitability challenges and an inability to differentiate their results from general investment markets.

“Against this background, buying large transparent, well-managed reinsurance companies with synergies in some areas of their existing portfolios is proving attractive.”

Acquisitions: the facts and figures

French insurer AXA acquired Bermuda-based XL Group for $15.3 billion (€12.4 billion) in cash. The price represented a premium of 33 percent to XL Group’s closing share price on March 2, 2018.

The move shifts AXA’s business profile from life & savings business to property & casualty (P&C) business. The deal enables the group to become the biggest global P&C commercial lines insurer based on gross written premiums, according to a company statement.

One of AXA’s motives in buying XL Group is the reinsurance portfolio it comes with, which will offer further diversification, and also the access to the capital markets that now comes hand in hand with this.

That was according to AXA CEO Thomas Buberl speaking during a March 5 presentation on the deal. He said AXA wants to retain the reinsurance business not least because of the access to financial markets it enables.

In addition to enhancing its global footprint with access to US and London markets, AXA is adding reinsurance operations to its portfolio. Gross premium written at XL Group’s reinsurance operations grew to $4.68 billion in 2017 from $3.98 billion in 2016.

“Reinsurance has been a core part of our operations at XL almost from its very foundation,” says Greg Hendrick, the chief operating officer of XL.

“It gives us an ability to enter into markets in a broad way with very limited infrastructure. More importantly it gives us a sense of what is going on in the market. We are able to see what is happening across the P&C spectrum,” Hendrick explains.

A focal point of the reinsurance business is alternative capital, as pension funds, sovereign funds, high net worth families want to participate in the property-catastrophe risk market.

XL Group wants to “bridge the gap between traditional reinsurance and insurance market into that alternative capital space,” Hendrick says.

Similar logic

For AIG, the logic has similarities. The insurer says it is taking over Validus in order to diversify the business into reinsurance and to add a Lloyd’s syndicate, management suggested in a January 22 conference call discussing the deal.

AIG entered into a definitive agreement to acquire all outstanding common shares of Bermuda-based Validus Holdings in a deal valued at $5.56 billion, funded by cash on hand.

The transaction enhances AIG’s general insurance business, adding a reinsurance platform, an insurance-linked securities (ILS) asset manager, a presence at Lloyd’s and complementary capabilities in the US crop and excess and surplus (E&S) markets.

“There are a lot of businesses that we don’t do, and therefore we were concentrated in too few for my liking,” said AIG CEO Brian Duperreault during the conference call.

Before the deal, AIG was operating neither in the reinsurance business nor in the Lloyd’s market.

The planned transaction includes Validus Re, a treaty reinsurer with a focus on property catastrophe, marine and specialty with gross premium written of $1.11 billion in the last 12 months as of September 30, 2017. After the transaction, Validus Re represents 3 percent of AIG’s total general insurance franchise, according to the presentation.

In addition, AlphaCat manages $3.2 billion on behalf of clients by investing in ILS products. This business represents 1 percent of AIG’s total general insurance franchise after the deal.

“I particularly like the reinsurance business as additive to what we do,” Duperreault said. While noting that retrocession rates had increased more than property-catastrophe after the third quarter 2017 cat losses, he said that he sees “great growth potential” especially in the AlphaCat capabilities.

AIG will also be entering the Lloyd’s market through the Validus deal by acquiring Talbot, a syndicate focused on short-tail specialty lines. The addition will broaden AIG’s technical underwriting expertise and provide access to distribution in the largest specialty insurance market in the world, according to the company.

“I’ve been interested in getting a Lloyd’s platform. We don’t have one and I think it is an important strategic asset to any general insurance company,” Duperreault said.

Talbot had $921 million of gross premium written as of September 2017.