Fitch Ratings indicates in a new report that capital market alternatives to reinsurance from sources such as cat bonds, collateralised quota-share reinsurance vehicles, or sidecars, and other risk transfer structures represent an increasingly viable alternative to the use of traditional reinsurance. However, to the extent that hardening insurance market conditions diminish into 2013, the agency says it expects less overall use of capital market reinsurance alternatives than recent experience in 2011/2012.

Fitch views the growth and acceptance of alternative reinsurance as a mixed benefit to reinsurers. Favorably, it represents an option to manage reinsurers' exposure and capital and serve as a source of fee income. Negatively, it represents competition for traditional reinsurers that, in conjunction with the strong overall capitalisation of the reinsurance industry, has worked to notably dampen reinsurance pricing momentum in 2012.

The agency believes that the comparatively high potential returns of catastrophe bonds and sidecar investments, and the lack of correlation between catastrophe losses and returns on other major asset classes should continue to contribute to strong demand from certain investors, including hedge funds, private equity, and institutional investors.

Convergence of the reinsurance market and capital market through cat bonds continues as 2012 is likely to have the highest total dollar amount of issuances since the prior record year of 2007. However, Fitch believes that several structural issues inherent in the market will likely keep cat bonds as a niche asset class in the near term, supporting US$5bn-US$8bn of annual volume and up to US$20bn of outstanding issuances.

Over the last decade the sidecar vehicle has emerged as a more efficient and flexible preferred option to traditional start-up (re)insurers. This is especially the case for the retrocessional property catastrophe market, where near-term pricing opportunities can be very advantageous post-catastrophe event, but also short lived.

Fitch also notes that most of the recent start-up reinsurers were created and funded by several well-known hedge fund managers seeking a more long-term asset management vehicle. It says it believes that the long-term future of this approach ultimately depends on its relative success over the entire market cycle.

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