Jeff Krohn and Andrew Feachem analyse the increasing prevalence of novel risk transfer solutions
The success of the US mortgage credit risk transfer (CRT) and European bank significant risk transfer (SRT) programs, along with broad macroeconomic uncertainty and evolving regulatory requirements, is accelerating demand for innovative capital and risk solutions among global banks.
The emergence of reinsurance CRT started in 2013, when the largest credit risk managers in the world, Fannie Mae and Freddie Mac, established their CRT programs. Each issuer established two primary platforms to transfer risk – a capital markets platform and a (re)insurance market platform. The platforms allow government-sponsored enterprises (GSEs) to take advantage of the different needs and appetites of each institutional capital base.
While the global capital markets may have a deeper combined investor base, the (re)insurance market provides a competitive advantage on a number of fronts. (Re)insurance CRT structures are not bound to the more rigid structural conventions required to access scale in the capital markets. The (re)insurance market tailors solutions for managing forward-flow business, not just closed pools of risk, and offers perfectly efficient amortisation structures tied to regulatory capital rules, not just the rigid principal and interest amortisation convention of capital markets, while providing faster turnaround times for transaction execution.
Relative pricing stability is another advantage of the (re)insurance market. Pricing volatility is common in capital markets that are inherently susceptible to exogenous market forces (e.g., liquidity, availability of leverage, relative return comps in other sectors). Reinsurers are “buy and hold investors” that do not trade in the secondary market, leading to pricing that is reflective of risk. They are much less exposed to external factors that make up the DNA of capital markets.
The relative pricing stability of the reinsurance market is evident looking back through some of the more recent turbulence in the financial markets created by COVID-19, widening interest rates and the invasion of Ukraine. The dislocation of the capital markets in 2022 enabled the GSEs to triple their annual reinsurance CRT issuance to USD 14 billion, further demonstrating the ability of the (re)insurance market to absorb capacity when capital markets dislocate.
Financial institutions are taking note of the GSE’s dual-platform strategy and are increasingly developing reliable (re)insurance partners to help them optimize capital, facilitate growth and improve profitability.
Bank issuers publicly disclose and actively discuss their CRT/SRT capital objectives in financial reports and earnings calls. While some banks view CRT/SRT as a tool to hedge downside risk, it is overwhelmingly being used by financial institutions to unlock upside by accessing more efficient sources and forms of capital to improve balance sheet efficiency and improve shareholder returns.
Questions remain, however. Will the banks and their regulators lean into the (re)insurance market in the same way the GSEs have? Will banks develop dual-issuance platforms? Will some banks recognize the competitive advantages of the (re)insurance market and choose to execute their first (re)insurance CRT/SRT transaction?
The onus is on the reinsurance market to be better capital partners and recognize that banks and their regulators are often not fully aware of the nuances of trading with the global reinsurance market. To bridge the knowledge gap, (re)insurers not only will need to show their willingness to write CRT/SRT, but they also must be very transparent and an active participant in the public policy forum, which is actively evolving in the US, UK and Europe.
Guy Carpenter and the other Marsh McLennan businesses have joined forces to offer banks strategic balance sheet solutions and a distinctive value proposition. With its comprehensive industry insights and solutions spanning the entire capital spectrum, Marsh McLennan is uniquely positioned to bridge the knowledge gap between banks, the capital markets and the (re)insurance market.