A new report from Howden has articulated a framework for introducing structured secondary trading for reinsurance, noting that such a development would allow carriers to more efficiently allocate risk and, in turn, improve overall capital utilisation.
The report emphasised reinsurance as a form of contingent capital, noting that by absorbing losses, it mitigates earnings volatility and lowers the risk exposure for both equity and debt holders.
“However, unlike debt or equity, reinsurance does not typically benefit from an active secondary market. Capital must be committed ex ante and priced to reflect the inability to rebalance exposures mid-term. This irreversibility introduces an implicit financing friction and increases the effective cost of contingent capital,” Howden Re explained.
According to the firm’s report, introducing secondary trading reshapes this dynamic, as the ability to defer, expand, contract, or exit a position as uncertainty resolves carries measurable economic value.
For those who need refreshing, a secondary market is a financial marketplace where investors buy and sell existing securities (stocks, bonds) or assets among themselves, rather than with the issuing company.
Unlike the primary market (where securities are first created), this market provides liquidity, allowing investors to easily convert assets into cash and enabling continuous price discovery based on supply and demand.
As Reinsurance News understands, the only true, liquid secondary market for reinsurance risks is currently in catastrophe bonds.
In catastrophe bonds, the secondary market is where investors and fund managers can trade positions with the assistance of a broker.
Catastrophe bond fund managers and investors use the secondary market to acquire positions and to sell positions, enabling them to buy attractive opportunities or to maintain diversification targets within their portfolios (read more on this at our sister publication, Artemis).
Howden observed that by separating origination from ongoing ownership, as other mature capital markets have done, reinsurance could embed optionality into its contracts, improving capital efficiency and supporting more efficient pricing.
The firm’s report continued, “Introducing a secondary market for reinsurance risk goes further than simply aligning it with other, more liquid forms of capital. It would allow carriers to more efficiently allocate risk and, in turn, improve overall capital utilisation.
“Increased liquidity should, in all likelihood, lower pricing and incentivise reinsurers to adopt and offer multiyear covers.
“That would, in and of itself, reflect the expected flexibility and greater optionality a deep liquidity pool would offer participants in a market that facilitates trading risk on and off to their needs.
“Such a development would support a healthier ecosystem by accommodating a participant’s financial backers through its potential for collateral release. The barriers faced by an emergent secondary market are those of implementation rather than principle.
“Therefore, realising the market entails a deliberate and guided approach, mindful of prior challenges. It demands a broker-led process, safeguarded by comprehensive risk management that is ultimately cognisant of the industry it is attempting to reform.
“Bringing reinsurance risk in line with more established secondary markets necessitates learning the lessons of those antecedents. Standardising terms and proliferating secondary-friendly language in treaties are well-tested tools readymade to aid this transition.
“Taken together, these measures would allow the market to evolve, consistent with its unique characteristics, and ultimately expand its role as a supplier of contingent capital.”
Rob Bredahl, Vice Chair, Howden Re and Chair, Howden Capital Markets & Advisory, commented, “In credit markets, secondary trading transformed static exposures into dynamic balance-sheet assets. We see the same opportunity in reinsurance.
“A functioning secondary market would let participants actively manage risk through the cycle, releasing capital when returns compress and adding exposure when pricing improves.”
David Flandro, Head of Strategic Advisory & Business Intelligence, Howden Re, added, “When reinsurance is treated as a third form of capital, the case for liquidity becomes obvious.
“Secondary trading turns static, hold-to-maturity contracts into flexible instruments with real option value. This, in turn, lowers the cost of capital for cedents while allowing reinsurers to allocate balance sheet capacity far more efficiently.”
