Aon: Reinsurers won’t cover cost of own capital, but raise new alternative capital

Broking giant Aon said that reinsurance companies included in its Aon’s Reinsurance Aggregate won’t cover their cost of capital in 2020, after loss ratios rose on the COVID-19 pandemic.

But the broker also noted that some reinsurance companies have been successful in raising new alternative capital, which of course begs the question of how the lower-cost of that third-party investor capital is contributing to reinsurer profitability.

Capital levels remained flat through the start of the year for the reinsurers Aon tracks for its Aggregate, but it is the impact of the novel coronavirus (COVID-19) pandemic that has dominated the financial results for the first half of 2020.

Reserves established for pandemic related claims have undermined the results and profits of reinsurance companies, driving them to an overall loss for the period.

“However, the capital base has remained resilient, after a strong capital markets recovery in the second quarter,” Aon said.

Premiums written are up though, as property and casualty (P&C) insurance and reinsurance gross premiums written (GPW) rose by 5% to $114 billion, assisted by risk-adjusted renewal rate increases, Aon said.

But the net combined ratio stood at 104.1%, with a 72.8% loss ratio and 31.3% expense ratio, thanks to COVID-19-related losses of $8.2 billion adding 9.7% and natural catastrophe losses another 2.8%.

As a result, the cohort of reinsurers that Aon tracks reported a net loss of $1.1 billion for the period, representing an annualised return on equity of -1.5%.

Which indicates that cost-of-capital has not been met and is unlikely to be through the rest of this year, given the pandemic still hangs over the industry.

Mike Van Slooten, Head of Business Intelligence for Aon’s Reinsurance Solutions, explained, “While it is already clear that the ARA will not cover its cost of capital in 2020, more positively, the group’s capital position remains robust, after a strong capital market recovery in the second quarter.”

However, the prospects in reinsurance look increasingly attractive to investors and this has helped reinsurers to attract new capital, both on the traditional equity side and also into their insurance-linked securities (ILS) structures.

Van Slooten said, “Several constituents demonstrated their financial flexibility by raising new funds, and others were successful in attracting new alternative capital to support their business positions, despite the challenging market conditions.”

One of the more interesting questions on reinsurance operational strategies and how they differ, is on the ability to make returns that cover their cost-of-capital and what levers are available to help them do so.

As reinsurers have been failing to cover their equity capital costs in recent years, they have at the same time expanded their third-party capital assets under management further, with the growth of insurance-linked securities (ILS).

In some cases, this use of alternative capital is one of the key levers that can enable a reinsurer to better cover the costs of their equity base.

In fact, given the typically lower-cost of ILS capital, for some reinsurers meeting their own cost-of-capital may now increasingly depend on their ability to attract third-party investors into ILS structures that they manage.

But how does that all play into the alignment of interests and are the alternative capital investors being treated equitably with the equity investors, or not? Questions that do need to be asked.

Evidence on this is sadly always lacking though, as we don’t get a sufficient look-through into how alternative capital assets really benefit reinsurers, or the specific way it augments their results.

But what does seem clear, is that the premise that alternative capital has a lower-cost associated with it, given the return requirements of these third-party institutional investors tends to be more focused on a fixed-income like return than an equity-like return.

Which allows reinsurers to utilise this as a key lever in their strategies, which to us makes the alignment even more important.

Managing this alignment going forwards, if meeting cost-of-capital remains a challenge, is going to become an increasingly important piece of reinsurer operations, we believe.

Those able to do that and demonstrate it through delivering returns to both sets of their investors may be the reinsurance companies that thrive in the currently hardening market.

They are almost certain to be the ones best able to raise more capital to both traditional and alternative sides of their balance-sheets, that’s for sure.