Casualty reserving challenges present legacy opportunity

Jarad Madea, CEO of Howden Capital Markets & Advisory, highlights how (re)insurance sidecars and legacy liability covers can help address casualty reserve challenges.

How do you view current casualty reserves held on balance sheets, and what are the primary factors driving the increases in reserves?

G lobally we are not seeing a net deficiency in casualty reserves, but there are pockets creating issues for certain insurers and reinsurers, for example: other liability, private passenger auto and reinsurance liability. It depends on the business line.

Where there are issues, the two biggest factors are financial inflation – the basic rise in costs – but also social inflation. We are seeing some juries giving out large awards, fuelled by the social environment and by some firms providing litigation funding. There’s also been a hardening in some of those casualty markets where rates for some of the lines are at their highest since pre-2010.

How will these reserve issues create opportunities for insurers, reinsurers and investors?

There are opportunities from an insurer, reinsurer and investor perspective. There are prospective and legacy opportunities for protecting the reserves of the business. There are also opportunities for new businesses – those coming in with a clean balance sheet and no legacy issues. They can benefit from the strong pricing environment today and where the pricing is going. We also have an interest rate environment today where you can make money on the reserves that are paid out over a longer period. There is also the opportunity of the sidecar structure both for investors and for (re)insurers.

What are the benefits and prospects of casualty sidecar solutions, and how is the demand for these solutions evolving?

For an insurer or a reinsurer, the first benefit is bringing in further capital sources to the insurance industry. Second, financial investors often have a specific strategy for the investments and their investment returns can mean the insurer or reinsurer can get better underlying economic terms. The third benefit is income for the insurer or reinsurer from providing the business flow to these vehicles. And then lastly, you're obviously getting protection from deterioration in those underlying conditions, and for future reserves, because you're offloading risk to a third party.

What do investors find attractive in these transactions?

A lot of investors have played in the cat ILS space, so they understand insurance and see it working on the property side. But obviously there's a lot of volatility in cat, so some are looking into how they can broaden out in the insurance or reinsurance sector.

From an investor perspective, casualty is less binary than cat risk, where many of those vehicles are either going to get your coupon or you could lose it all. Casualty is also much longer duration liabilities, which allows for a more sophisticated asset strategy and investment returns that are attractive in today's environment.

What’s more, they're not only investing in the underlying return. As the asset managers, they're getting fees for managing those assets.

What key trends are you seeing in the legacy market? Are there any new solutions or entrants?

There are a lot of insurers and reinsurers looking for transactions to mitigate future reserve risk and to free up capital for current organic growth. Over the last couple of years, we've seen many well-known legacy specialists exit and a decreased supply of capacity. The last three deals we've done at Howden on the legacy side were all with non-legacy market specialists looking to offer those solutions.

But now there continues to be a lot of interest from the cedants’ perspective and I think we will see some of those traditional legacy players getting more active in the market.

What are the implications and outlook for M&A regarding casualty reserves?

Casualty reserves can be a hindrance in M&A deals as buyers and sellers may have a differing view on the reserve risk. A legacy deal may be a potential solution where a third party comes in and provides the reserve protection, but that also brings an incremental cost which can further widen a valuation gap.

When there is a big difference between bid and ask, then no solution is going to get that M&A deal over the line. But we are seeing this change, both in terms of buyers’ lower organic growth prospects and a potential reduction in valuation expectations among sellers. So, we are getting to a place where these types of reserve solutions, and the sharing of those incremental costs, can be agreed more easily.

Where is HCMA innovating or leading in this area?

It's hard for any team that operates in a silo to to deliver in this area and we've been successful in bringing some of these solutions to market because of the coordination and close collaboration between our teams – casualty reinsurance broker, ILS, legacy liability, actuaries, the rating agency team and so forth.

On the investor side, we've spent a lot of time identifying potential investors, educating them on these structures and matching their risk, return and duration appetite to insurance and reinsurance client capacity needs.