In a long interview with Intelligent Insurer, Munich Re's Torsten Jeworrek said many of the things we expected to read.  We noted his comments about how it will take more than a single large loss to move the markets. We noted his comments about his belief that a change in the market climate will come from "a series of losses and other incidents --including further consolidation, or even insolvencies, worsening of results."

We've noted in the past that it may not take a major catastrophe to tip reinsurers to a negative underwriting ratio so Jeworrek's observation validated the idea that some highly placed executives are monitoring claim losses reported by competitors and matching them against reported surplus. We noted, too,  Markel's Global Reinsurance president Jed Rhoads observation that "Some reinsurers are perceived as too big to fail, but we've heard that before in the banking industry."

We noted too, Jeworrek's belief that "Large amounts of previously not available data and sophisticated analysis methods will improve risk assessment and claims handling." After we realized it would be indelicate to immediately email him about the CATEX Data Vera product, we ticked the box indicating that Munich Re remains in the vanguard of those looking for ways to monetize "big data".

Then we noticed this. Jeworrek said that he believes that the durability of so-called alternative capital is yet to be tested by a big loss and some investors will inevitably leave the market in the aftermath of such an event.  He went on to say that some of the business models being used by alternative capital, such as hedge fund reinsurers, were unsustainable and noted that "Pension funds provide the majority of the alternative capital. They search for stable returns and diversification and continuously increase the share of alternative asset classes within their investment portfolios."

He continued with the clincher --"But their sustainability hasn't yet been tested by a huge cat loss. I assume that a certain amount will stay in the market following an event or change in the interest rate environment but some will leave for sure."

Torsten Jeworrek is one of the most respected voices in the industry and his comments were a surprise to us.  After all, everything we have been reading is talking about the increasing convergence of alternative capital and traditional reinsurance. There is hardly a week that goes by without some reinsurer noting that it has successfully incorporated alternative capital as part of its offering being able now to better match less expensive capital with lower premium producing risk.

But then we noted other comments this month from Kean Driscoll, CEO of Validus Reinsurance. Speaking at an event in Bermuda, Driscoll observed that he believes that the ILS market is going to increasingly look to the benefits of a so-called rated balance sheet in the future rather than focus exclusively on collateralized products. He said "I expect we're actually going to see the ILS community shift towards rated-balance sheets. They're realizing that buyers like rated paper, they like the promise to pay, they like the temporal flexibility, so I think we're going to see more rated paper."

Rated paper or a rated balance sheet has always been central to insurance. A promise to pay for a loss might not mean very much if the promisor won't have the money to pay a claim. Ratings agencies review insurer and reinsurer balance sheets and it's an arduous process. The A.M Best methodology is an example. If done properly, and there is a great deal of incentive to insure that it is, there is little a ratings agency doesn't know about a risk bearer's finances before they assign it a ratings grade.

From the perspective of a buyer of coverage this assurance is key. Most cedents have so called "security lists" that mandate that coverage can be purchased only from reinsurers maintaining a certain minimum ratings level.  When ILS capital was introduced to reinsurance ILS investors could hardly apply for a ratings agency rating.  The invested funds essentially would come together only to underwrite a specific risk or instrument. The solution was for those investors to put the money in up front and fully collateralize the buyer against a loss. The ILS community reasoned that if the cedent could see the money sitting in a designated financial institution, and was contractually permitted by the policy to access the money in the event of specified losses, then the need of a cedent for "rated paper" would be mollified.

This process has worked well and has enabled the growth of the role of alternative capital in reinsurance.  For the ILS investor the premium paid by the cedent is potential profit, as is any interest gained by the deposited funds sitting in escrow.  But if there were claims then not only was the profit upside from the paid premiums and interest lost, but the potential of the loss of the entire invested principal amount itself existed.  We're possibly seeing this unfold right now with the Gator Re CAT bond which at last report was at 94% of the way to hitting its attachment point figure. With two months of 2016 left to accumulate losses it's possible that investors could lose principal.

That's why we were surprised when we saw Alleghany's EVP Joe Brandon observe at the same conference " Having this collateralized capital has actually highlighted the benefits of a rated balance sheet, which is not an outcome I would have expected a couple of years ago."

These were surprising observations we thought.  One of the reasons alternative capital has been successful is because it can compete effectively (and less expensively) against the cost of maintaining a rated balance sheet composed of shareholder equity, surplus and premium float possessed by traditional reinsurers.  It's a bit like a "one-night stand" compared to a long marriage, but if pricing is the cedent's primary motivation then non-traditional solutions seem to fare well.

Apparently though the observations of Brandon and Driscoll mean that something else is driving cedents and it's not just price.  We were tipped to this in an article in Intelligent Insurer headlined "Buyers show mercy on pricing".  Apparently larger buyers of reinsurance are concerned that reinsurers are struggling to make profits in the soft market with one big buyer, Allianz, going so far as to say that they won't seek further rate reductions but are interested in only stable, sustainable pricing.

We do understand that a buyer of any product could come around to having genuine concern about the industry that supplies that product if that supplier sector has fallen on hard times. If the product is important the buyer wants to be certain it can continue to be obtained.   Theoretically we understand that, but practically speaking we are hard pressed to recall any purely altruistic actions similar to what buyers such as Allianz demonstrated.

Then we noticed several articles noting that reinsurance buying patterns have shifted among several large buyers from safeguarding their own balance sheets to include protecting against earnings volatility. Mike Foley, CEO of Zurich North America, a reinsurance buyer, says "There are places that we might have been purely focused on balance sheet and capital protection but given the market and where we are now we see opportunities to protect against some of the earnings volatility too."

Munich Re's president of US reinsurance Steven Levy told Insurance Insider that a "growing number of large clients, most of whom are in possession of very strong balance sheets are buying more reinsurance to 'enhance their earnings ability'". 

Obviously Allianz and Zurich have quite strong balance sheets already but as Amer Ahmed, CEO of Allianz Re (which is charged with reinsurance buying for Allianz) says "The decision to manage the volatility in its earnings is a conscious one made by management at Allianz." He said that while Allianz has the balance sheet to bear large losses it was conscious of the variance it's willing to accept in its earnings (caused by potentially large losses) and uses reinsurance to hedge this.

Now the comments made by Brandon and Driscoll began to come into better focus.  If cedents are concerned about the effects of unfavorable reserves, diminishing primary insurance pricing or an end to the period of benign CAT events, and have used reinsurance to protect their balance sheets then buying more coverage in this soft market to further hedge against earnings volatility is a very logical move.

Perhaps we are gaining a view of the future dividing line between so called "one-night stands" and long term marriages --or the differences between ILS and rated balance sheets --and this may have been what Brandon and Driscoll were thinking when they noted the increased importance of strong reinsurer rated balance sheets to cedents.

We would note though that there are always arguments for both sides.   Alternative capital providers can replicate rated balance sheets via transformers and in many cases by joint ownership ventures with rated reinsurers.  Suffice to say that one takeaway from this discussion though is that the importance of a rated balance sheet on the part of a traditional reinsurer means that predictions of impending doom for traditional reinsurers may be premature.