A new report from Howden sets out a framework for the introduction of structured secondary transactions in reinsurance, noting that this development will enable insurers to allocate risk more efficiently, thereby improving overall capital utilization.
The report highlights reinsurance as a form of contingent capital, noting that by absorbing losses it can mitigate earnings volatility and reduce risk exposure for equity and debt holders.
“However, unlike debt or equity, reinsurance does not typically benefit from active secondary markets. Capital must be committed ex ante and priced to reflect the ability to rebalance risk in the medium term. This irreversibility creates implicit financing frictions and increases the effective cost of contingent capital,” explains Howden Re.
The introduction of secondary trading reshapes this dynamic, as the ability to defer, expand, contract or exit positions has measurable economic value as uncertainty resolves, according to the company’s report.
For those who need a refresher, the secondary market is a financial market where investors buy and sell existing securities (stocks, bonds) or assets rather than with the issuing company.
Unlike primary markets (where securities are first created), this market provides liquidity, allowing investors to easily convert assets into cash and enables ongoing price discovery based on supply and demand.
Reinsurance News understands that currently the only real, liquid secondary market for reinsurance risk is catastrophe bonds.
In cat bonds, the secondary market is where investors and fund managers can trade positions with the help of brokers.
Cat bond fund managers and investors use secondary markets to acquire and sell positions, allowing them to purchase attractive opportunities or maintain diversification goals within their portfolios (for more information on this, see our sister publication Artemis).
Howden observed that by separating origination from ongoing ownership, as other mature capital markets do, reinsurance can embed selectivity into its contracts, thereby improving capital efficiency and supporting more efficient pricing.
The firm’s report continues: “Introducing a secondary market for reinsurance risk is more than just combining it with other, more liquid forms of capital. It will enable insurers to allocate risk more efficiently, thereby improving overall capital utilization.”
“The increased liquidity is likely to lower pricing and incentivize reinsurers to adopt and offer multi-year coverage.
“This in itself reflects the expected flexibility and greater selectivity that deep liquidity pools will provide market participants, thereby facilitating risk trading according to their needs.
“Such a development will support a healthier ecosystem by accommodating financial backers of participants through the potential unlocked by their collateral. The barriers facing emerging secondary markets are ones of implementation rather than of principle.
“Realizing the market therefore requires a considered and guided approach, keeping in mind previous challenges. It requires a broker-led process, underpinned by comprehensive risk management, that ultimately understands the industry it is seeking to revolutionize.
“Lessons from these precedents must be learned if reinsurance risk is to be aligned with more mature secondary markets. Standardized terminology and extensive use of secondary market-appropriate language in treaties are well-tested and readily available tools that can help achieve this transition.
“Taken together, these measures will enable the market to evolve in line with its unique characteristics and ultimately expand its role as a supplier of contingent capital.”
Rob Bredahl, Vice Chairman of Howden Re and Chairman of Howden Capital Markets & Advisory, commented: “In credit markets, secondary transactions transform static exposures into dynamic balance sheet assets. We see the same opportunity in reinsurance.
“A well-functioning secondary market will allow participants to actively manage risk throughout the cycle, freeing up capital when returns compress and increasing exposure when pricing improves.”
David Flandro, head of strategic consulting and business intelligence at Howden Re, added: “When reinsurance is viewed as a third form of capital, the importance of liquidity becomes clear.
“Secondary transactions transform static hold-to-maturity contracts into flexible instruments with real option value. This in turn reduces the ceding company’s cost of capital while allowing reinsurers to allocate balance sheet capacity more efficiently.”
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