Going retro: How recycling capital through customised and structured solutions can generate better returns
A tougher economic backdrop combined with a tightening of reinsurance capacity is prompting Asia Pacific insurers to look at optimising their balance sheets and consider new operating models. Jim Atwood and Roshan Perera explore the rising popularity of retrospective solutions in the region.
Reinsurance renewals during 2023 revealed a strong emphasis on price and contract conditions across all areas and lines of business, with reinsurers taking a more disciplined and cautious approach in deploying their 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 a tightening of capacity relative to demand.
That tightening of supply could be particularly acute for operators in Asia Pacific (APAC). One contributor to the supply/demand dynamic is inflation. While inflationary pressure across APAC has been a less prominent topic compared to Europe or the US, the region was not entirely immune. Inflationary effects were seen in several countries and APAC is also experiencing the weakening of local currencies, while disruptions to supply chains arising from the Covid-19 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 insurer’s 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.
Global growth engine
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 drive demand for capital solutions and resources, including GDP growth and post-pandemic economic recovery boosting demand for insurance, alongside governmental and social pressure to address the protection gap.
At the macroeconomic end, issues such as exchange rate and capital market volatility are increasing demand for such solutions, as are factors closer to home including increased claims inflation, leading to pricing revisions and increased solvency and capital requirements.
As companies seek to optimise performance, there will be a trade-off between growth, profitability and solvency. To better manage risk and capital, structured and customised 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 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’ markets that can be optimised for both existing and ongoing capital funding needs.
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 – for example, a reserve quota share, aka loss portfolio transfer – 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.
In the current environment, cedants are likely to weigh the benefits of retrospective solutions against retaining assets to avoid crystallising unrealised 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 minimise 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.
Insurers considering retrospective solutions as a vital addition to their capital management toolkit need to have confidence that they can find the correct acquirer – one with the appetite and ability to transact, plus the right partnership mindset.
This is where a broker can add considerable value and cedants should consider those with broad skillsets that can be deployed in support of their transaction, including actuarial, capital, accounting, claims and project management capabilities. Deal flow is also important. Brokers with a high rate of deal-flow demonstrate strong relationships with the market’s key legacy acquirers.
Jim Atwood is chairman of strategic solutions for APAC, and Roshan Perera is executive director and head of strategic solutions for APAC, at Gallagher Re
The above is an excerpt from Gallagher Re’s recent blog focused on capital recycling in APAC, originally published on 19 September 2023. For the full blog, please visit:‘Growth ambitions: recycling capital for better returns’