Overcapacity in the Reinsurance Industry

The reinsurance industry is a highly competitive globalized industry. It faces several challenges from all over the world. The issue of overcapacity in the reinsurance industry is one of the prominent challenges facing the industry. This overcapacity is affecting the reinsurance industry in several ways.

In this article, we will understand the root cause behind overcapacity in the reinsurance markets as well as the various ways in which it affects the different players in the industry.

Root Cause Of Reinsurance Overcapacity

Overcapacity was not always an issue in the reinsurance industry. In fact, for a long time, the reinsurance industry was suffering from a shortage of capital. Over the past couple of decades, this shortage of capital has turned into a situation where excess capital is now available. The reason behind this colossal influx of capital has been listed below:

1. Reinsurance as an Asset Class: It is important to note that over the past few years, investors who are not directly related to the reinsurance industry have started viewing reinsurance as an asset class. This is because of the relatively high return on equity that reinsurance had offered in the decade before.

   The end result has been that just like people invest money in shares and bonds, a certain percentage of the global funds have been regularly allocated towards the reinsurance industry in the past few years. The fact that large sums of money have been allocated almost every year has led to a situation where excessive capital is available in the reinsurance market.

2. Investment Capital as an Alternative: Over the past decade or so, specialized financial instruments have been created in order to ensure the supply of money to the reinsurance market.

   Instruments such as catastrophe bonds are being used all over the world. Investors such as hedge funds and high-net-worth individuals are providing a lot of capital to the reinsurance industry. This capital is different from the regular promoter-led capital which is being infused into reinsurance corporations.

3. Access to Global Capital: It is important to realize that the market for reinsurance is a truly globalized one. It is common for ceding insurance companies to reinsure their risks with reinsurance companies located in a different country.

   It is also common for reinsurance companies to have access to capital from across the world. This is the reason that the scarcity of capital in individual geographical markets does not have a huge impact on the availability of capital in the reinsurance markets.

Impact of Reinsurance Overcapacity

It is important to realize that the overcapacity in the reinsurance business is negatively impacting the entire industry in several ways. Some of the prominent negative effects of the reinsurance industry have been explained below:

1. Lower Margins: When excessive capital floods the reinsurance market, there is overcapacity in the market. Also, since a lot of the capital is owned by investors, they are comparing the returns with other asset classes instead of comparing it with other reinsurance companies. Over the years, this has led to very aggressive pricing. This pricing has cut down the margins of many prominent reinsurance companies across the globe.

   Lower margins have a negative impact on the overall industry since they exert an artificial downward pressure on all the associated costs.

2. Idle Capital: As mentioned above, the tsunami of capital inflow has led to lower margins. There are some reinsurers who are accepting business with lower margins whereas there are some other reinsurers who refuse to accept such business.

   It is important to realize that such businesses tend to have a lot of uninvested capital on their books.

   The market penalizes companies that do not accept lower-margin businesses. This is because the market looks at these companies as inefficient since they have not been able to meaningfully deploy the capital which is available to them. Hence, the influx of excessive capital impacts even those firms that do not directly participate in the price wars.

3. Weeds Out Smaller Players: The influx of excessive capital does not equally impact all the players in the reinsurance business. The larger players tend to benefit more since they have established businesses.

   Investors are more comfortable investing in large reinsurance companies. Hence, the disparity of capital is further exacerbated by the influx of investor capital. The end result is that the portfolios of established companies are large and diversified. On the other hand, smaller companies struggle with price wars as well as the inability to attract more business. The end result is that smaller players get weeded out with time. Large inflows of capital have caused consolidation within the reinsurance industry.

4. Excessive Risk Taking: Last but not the least, smaller reinsurance companies do not go out of business without a fight. A lot of reinsurance companies tend to take on excessive risk in order to stay afloat in the market. This is most commonly done by including reinsurance covers for war, terrorism, and cyber-attacks with regular insurance covers.

   If any big event takes place, it places the entire business of the reinsurance company at risk. In order to compete, more reinsurance companies are forced to undertake excessive risk. The end result is that the risk tolerance level of the entire industry is forced to undergo a change.

To sum it up, reinsurance companies are facing lots of challenges because of the influx of excessive capital. It is likely that the market will adjust itself and the supply of capital to this sector will moderate within the coming years.