Characterizing the threat of third-party capital as an “adrenaline shot to the heart” of U.S. and Bermuda reinsurers, A.M. Best urges the reinsurers to innovate beyond simply managing capital of investors in a report published Monday.

With the shot spurring “fight or flight” survival instincts, “more creativity may be needed in the long term to stay relevant,” analysts from the Oldwick, N.J.-based rating agency write in the report, “Stuck in the Middle: Reinsurers Face Converging Capital, Rising Retentions.”

Noting that much of the third-party capital entering the reinsurance industry today prefers property-catastrophe risk, the analysts predict it will spread to other lines “and continue encroaching on reinsurers’ turf” in the days ahead.

“This external capital is vast and becoming more comfort­able with reinsurance risks. It is very likely to continue to increase its presence in some manner,” the report says.

In response, “reinsurance companies can close their eyes, click their heels three times and hope they go off to a different place in time.”

In the absence of magic, Best suggests that reinsurance companies should pursue risks that require innovative market solutions—giving the example of insurance gaps that persist in natural disaster scenarios.

“Large catastrophic events produce two sets of numbers, insured losses and economic losses, with the economic losses sometimes substantially higher,” the report says, noting that this situation will prevail for Typhoon Haiyan in the Philippines. “This is also the case with events that hit the United States, despite it being a deeply developed (re)insurance market.”

Risks falling in these gaps are complex and difficult to underwrite, but reinsurers are in the best position to put their intellectual capital to work to assess them and to “provide innovative products that offer market solutions,” Best notes, suggesting that third-party investors increasingly providing monetary capital to “data-rich, heavily modeled and high-margin property catastrophe risk” may be the “driving force” for this change.

In addition to the flood of external capital into the reinsurance market, the Best report reiterates two other issues outlined in an earlier report, “The Capital Challenge,” published in late August—traditional reinsurers with too much capital chasing the same opportunities, and primary companies retaining more risk.

Best reports that reinsurers are actively managing capital, with share repurchases for roughly at 50 percent of net income for Bermuda companies through the first nine months of 2013.

While growth in shareholders’ equity has outpaced net written premiums in recent years—with capital growing 11 percent since 2008 and premiums only 2.5 percent—Best notes that Bermuda companies with hybrid insurance and reinsurance models are showing better premium growth, while capital management and unrealized investment losses ease capital growth.

On the topic of the growing competition of capital markets, the Best report references the possibility that underwriting standards will drop. “Securitization also can diminish the relationship aspect of the reinsurance industry,” the report says.

Beyond this, Best suggests that in claims situations, where contract wording is open to interpretation, reinsurers, unlike third-party investors, “may willingly pay claims at the margin.” This exposes insureds to credit risk, the report notes.

“This has yet to be seen on a grand scale, but one day the industry will find out the answer,” the report says, also reiterating questions about the long-term commitment of third-party capital raised in the earlier August report.

Source: A.M. Best