Hitting the Alt Key Hits Commissions

Right now alternative capital probably hasn’t had a huge impact on your business. Unless you sell reinsurance, you might not even have noticed it’s there.

But if you broker catastrophe-exposed property cover, you’ve probably sold policies backed in part by investments from the capital markets. The price of those policies is probably a little bit less than it would have been without that money. U.S. commercial property insurance rates are flat, and they’re expected to start declining soon. Cheap reinsurance is one thing that has halted their gentle rise, and alternative capital is a big factor behind cheap reinsurance.

If you’re a property reinsurance broker, especially one involved in retrocession business, life has already changed. If you work at one of the big broking houses, as much as half of your business has already walked across the hallway to your company’s capital-markets subsidiary (effectively, a mini investment bank). If you’re at a small, specialist reinsurance brokerage, some of it has probably walked out the door. Either way, at every client meeting you have, they’re asking about alternative solutions and the credit-risk-free reinsurance that the capital markets have on offer.

So far the financial markets haven’t had a significant impact in direct insurance lines or in casualty. But they are coming. The risk transformers—especially the capital-markets operations of the big reinsurance brokers—are experimenting. They’re working on ways to make alternative capital viable in non-catastrophe lines. It is only a matter of time before they are successful—and that will make insurance less expensive. Business interruption is one line currently in their sights, and it’s the biggest concern of risk managers around the world. It would be easy, for example, for the capital markets to cover business interruption due to earthquakes.

But already alternative capital is trickling down to suppress prices in other direct insurance lines. “Sidecar” vehicles can provide cheaper quota-share reinsurance than traditional carriers (see “Bluffer’s Guide”), which in turn can make every kind of insurance policy cheaper. As the popularity of such banker-backed reinsurance grows, the soft market that lies ahead could be made both broader and deeper. For brokers already operating on fine margins, wading through could be treacherous.

In at least one high-profile case, a client has gone to the capital markets to obtain catastrophe cover with no third-party carriers involved. Their specialist broker and captive insurer did the deal. That’s only viable for the largest corporate accounts, but if you broker to big corporates, they’ll soon be asking about it. Brokers are integral to these and all capital-markets insurance and reinsurance transactions since insurance buyers still need help matching their risks with appropriate underwriters, no matter where the money is coming from. But when the capital markets are providing the cash, the brokers doing the deal are different individuals, sometimes working for different parent companies. The products they sell are not regulated like regular policies, because the buyer, not the carrier, holds the capital backing the policy. Officially, they’re not insurance.

From the investor’s perspective, collateralized insurance (or reinsurance) is essentially an asset-backed security. Some risk wizards have taken the various alternative-risk transfer instruments and packaged them up, bundling slices of collateralized reinsurance contracts, sidecars and cat bonds into a tradable dollop of risk. Such financial alchemy has made headlines before: when mortgages were being packaged up and sold. The results of that experiment were catastrophic, as everyone knows, because the original lenders became complacent about the quality of the borrowers (so unconcerned, in fact, that NINJAs—folks with No Income, No Job or Asset—could borrow money for a house).

If underwriters were to stop caring about losses because some faceless financiers were holding the bag, the industry could face disaster as the mortgage market did. Right now that eventuality seems unlikely because the new insurance investors have been extremely interested in the statistical likelihood of losses. But what if that likelihood could itself be insured? It happened with the mortgage-backed securities, which were “protected” by “insurance wrappers.” If that were to happen with ILS products, the landscape would change completely. If such a move seems far-fetched, would you have believed that insurers would routinely and gleefully cover mortgage defaults by NINJAs?

Happily, at present, investors in insurance-linked securities (the ones that have made the big impact, at least) are cautious players with a long-term horizon, and a complete, hostile takeover of insurance capital supply by bankers is a long way off. It may not come at all. And bottom-line prices cannot fall too far, at least not for long, since in the medium term insurance simply has to be sold for more than burning-cost. A margin has to remain. Already, perhaps, some capital-markets investors are deciding that property catastrophe reinsurance is too cheap (even as some traditional players chase the market down). That’s one reason they are looking at other lines of business.

Even if price pressure is muted, brokers are being urged more than ever to develop innovative approaches, especially in reinsurance. That trend is set only to continue and intensify as the penetration of capital markets money into the sector continues. “To survive,” says David Flandro, Global Head of Strategic Advisory at JLT Towers Re, “brokers can no longer simply provide capacity. In a world of overly abundant capital, distribution is no longer an advantage. Only those with the most innovative solutions and best ideas will survive the long term, which is how it always has been.”