The capital market felt its fair share of shocks in 2022. The double whammy of increasing interest rates combined with equity and bond market portfolios trading well below historic averages has generated a material mark-to-market negative adjustment to company financial statements. And the result? Substantial unrealised losses across the board.
The economic slump that set in last year was compounded by heightened natural catastrophe exposures and loss experience resulting from an active US storm season headlined by Hurricane Ian. Paired with rising interest rates, this translated to lower investment yields across the board. Meanwhile, currency fluctuations in foreign exchange also restricted the amount of capacity being deployed.
“It was the perfect storm,” says Kelly Superczynski, head of capital advisory at Aon’s Reinsurance Solutions. “We had the biggest loss of capital in recent history, coupled with the fact that capital hasn’t flowed back into the market like it normally does after an event, which has created a very challenging situation.”
She explains that these interconnected challenges prompted reinsurers to withdraw certain coverages and increase rates by as much as 50% at the January 2023 renewals. Pricing for US property catastrophe and global property retrocessional businesses, in particular, peaked at multi-decade highs.
According to Aon’s April 2023 Reinsurance Market Dynamics report, the net effect was that available global reinsurance capital declined by 15% - or $100bn – over the year to December 2022.
All that’s to say that insurers needed to be extremely careful about how they deployed the limited capital at their disposal coming into the January renewals. So, with 2023 well underway and a complex risk environment still to consider, how is the insurance sector adjusting its investment portfolios?
Superczynski suggests that some insurers are leaning towards a big-picture approach which allows them to process challenges with an emphasis on outcomes that can temper risk appetites. This often means bringing together data-driven modelling and stress testing to determine the impact of multiple scenarios on investment portfolios at once. As macroeconomic shifts threaten to disorient decision-making, forecasting exercises can set the table for clearly defined strategic direction.
Given the ongoing volatility of the current economic cycle, it can be easy to fall into the trap of adopting an episodic outlook. Regardless, Superczynski urges insurers to focus their access to capital on delivering a consistent and stable outlook. She defines this outlook as one that requires a single source of truth, and that takes a long-term view of risk. The alternative - shoehorning data into a predetermined narrative to fit with the consensus at a particular point in time - is a zero-sum game.
“We saw that play out at the January renewals,” says Superczynski. “Because reinsurers were able to be selective in who they provided capacity to, those companies that had solid data and consistent results and, as a result, could tell their story most effectively, secured the limits they needed. Those that didn’t had a much more challenging time.”
On route to developing a consistent outlook, companies have had to adapt their strategic approach to risk management, taking a more considered view of their capital allocation and being led by the data.
“The ability to demonstrate thoughtfulness and a data, fact and experience-driven approach and eliminate volatility ultimately leads to greater stability,” says Sherif Zakhary, CEO of Aon’s strategy and technology group. “That also enables companies to tell their own compelling story to differentiate themselves from the competition when it comes to securing capacity.”
The insurance sector is heavily regulated and frequently assessed by rating agencies, meaning a conservative approach to managing capital and risk often takes precedence. This dynamic requires insurers to hold a large amount of capital to cover their exposures while trying to get a consistent return on their assets.
To optimise their capital, insurers need to first carefully think about the type of capital they want to use, whether that’s traditional or structured reinsurance, debt or equity. That may include using a vehicle such as a sidecar or a captive. By the same token, they must also be realistic about the capital pools they can access.
The next step is to consider the risks they have to cover and decide how to allocate the capital. Once that capital has been deployed, its performance must be monitored regularly, and adjustments to the placement can be made if necessary.
“Companies need to get the right balance between different types of capital if they are using more than one,” says Superczynski. “Then they need to decide how they are going to best align their risks with that capital, which will determine how it is deployed most effectively.”
Most of the capital that is still coming in originates from the legacy market, according to Superczynski. “That market has grown exponentially from $5bn to $20bn in the space of just six years. It represents a huge opportunity for companies seeking capacity,” she says.
As Superczynski sees it, the bottom line is that collaboration, resources and financial analysis solutions will play a critical role in allowing insurers to navigate a complex capital market in 2023. Effectively calculating how much economic and regulatory capital is required in real-time lets organisations make more informed decisions, respond nimbly to market shifts, and take advantage of new opportunities.
“Ultimately, capital is the glue that holds organisations together,” Zakhary says. “So knowing how to deploy it effectively, particularly in these difficult economic times, is paramount to a company’s success.” He concludes with the assertion that understanding the true cost of capital, including the volatility of its returns, is the bedrock for any business to optimise its long-term returns.
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