Catastrophe bonds and other alternative reinsurance vehicles have had a surge of capital inflow this year, and investors will continue to put larger shares of their portfolios into alternative reinsurance as long as interest rates remain low, says UBS analyst Brian Meredith.
Alternative reinsurance currently accounts for about 14 percent of global catastrophe reinsurance (about $45 billion), doubling in the last five years, and Meredith thinks that it could double again in the next five. RenaissanceRe Holdings Ltd. (NYSE:RNR) and Vision Reinsurance (VR) are especially good values right now because they have underperformed the market in recent years. “At current valuations, we see limited downside for both stocks,” says Meredith. “We believe valuations will rise over the long-term (3+ years) as RenaissanceRe Holdings Ltd. (NYSE:RNR) and VR take advantage of the influx of alternative capital to improve risk-adjusted returns. For RenaissanceRe Holdings Ltd. (NYSE:RNR), we estimate that the stock could conservatively generate a total return of 65% over the next three years.”
Understanding alternative reinsurance
Alternative reinsurance encompasses several different strategies, but insurance linked securities (ILS) are the vehicle that is used to transfer insurance risk to capital markets. ILS can be used for property-catastrophe risks, or for any type of risk that can be quantified with a model (at least to the satisfaction of investors). The use of additional ‘sidecars’ gives investors the option to be more directly exposed to a reinsurance company’s profits or losses. Catastrophe bonds transfer the risk of a specific event or event category to capital markets for a set period of time; industry loss warranties (ILW) are triggered when losses in a specific industry hit a given threshold and are often structured as indemnities; collateralized reinsurance are similar to traditional reinsurance but they don’t have a financial strength rating and the risk is collateralized by the capital provided by the investor.
Alternative reinsurance has a lower cost of capital
While alternative reinsurance has a lower cost of capital than traditional reinsurance, especially in a low interest environment, there are some additional risks associated with them. Specifically there is a limited reporting period (because collateral has to be released to investors), but claims related to some natural disasters can accumulate over many years. There is also the lack of reinstatement provisions. “Because alternative reinsurance investors pre-fund a potential loss through collateral, it cannot guarantee that funds will be available for a reinstatement limit after a loss,” says Meredith. “That said, some alternative reinsurance has found ways around this through fronting arrangements (where another company guarantees that the funds will be available), aggregate reinsurance protection, and other structures.”