Tighter regulation, increasing capital requirements, could give catastrophe bonds an edge

The insurers and reinsurers of this world are currently operating in a changing regulatory and legislative environment, with greater focus being placed on risk management, capital adequacy and risk capital requirements as rulemakers seek to ensure the industry is sufficiently shored up to cope with major events. The economic climate is increasing the focus on the insurance and reinsurance industries as the bailouts of banks and financial institutions make rulemakers nervous and keen to ensure a certain level of capital is maintained within the market.

Changes to the regulatory environment, such as the long-prepared for Solvency II, will increase the focus on world-class risk management and capital adequacy forcing insurers and reinsurers to be more prepared than perhaps they have been historically for peak events and risks. According to this article in Business Insurance, a panel of reinsurance executives at the International Insurance Seminar in Rio, Brazil, said that they believe the increased cost of complying with the new capital requirement rules will force insurers and reinsurers to pass these costs onto consumers and end-users of their services.

The increased focus on risk management and the pressure to ensure the adequacy of your risk capital provisions and also risk transfer provisions could result in more business for reinsurers. Primary insurers will be forced to look at the way they transfer risk in a new light and this will result in more risk being transferred down the chain to reinsurers.

But the increased capital requirements, said the panel, means that both insurers and reinsurers are likely to pass costs back to consumers and end-users resulting in increased prices for insurance and reinsurance coverage.

Now this will please many in the reinsurance sector who feel that their rates need to rise in order for the industry to maintain stability and be sustainable. Of course for a lot of newer reinsurers the capital adequacy issue will not matter as they maintain full collateralisation of the risks they underwrite through capital market investor participation, for this breed of reinsurer there could be a chance to capitalise on the increasing desire for insurers to acquire adequate reinsurance cover. But with insurance rates, and therefore reinsurance rates, expected to rise, what will or could that mean for the catastrophe bond and insurance-linked securities market?

Solvency II as a piece of regulation is expected to increase interest in cat bonds and ILS anyway as many potential sponsors from the re/insurance space will look closely at them as a way to transfer risks off balance-sheet and therefore assist their capital adequacy and risk capital provisioning metrics. With capital market institutional investor interest in the space expected to continue to grow, this suggests that the cat bond and ILS space could be very well positioned to take advantage of the new regulatory environment when it comes into effect.

The interesting factor which could further stimulate interest in cat bonds and ILS in an increased regulation and capital requirement world and re/insurance market is pricing. With re/insurance rates expected to rise due to the increased cost of maintaining these more stringent capital requirements there could be an opportunity for cat bonds, ILS and indeed other capital market risk transfer solutions to increase their cost-competitiveness and become even more viable alternatives for potential re/insurance sponsors.

We’ve written recently about the possibility that catastrophe bond pricing is becoming decoupled from reinsurance market pricing and this could be a trend that increases as the new regulatory environment comes into play. As more investor capital flows into or shows interest in the cat bond and ILS space the ability for pricing to be set more attractively increases. If insurance and reinsurance rates are forced to rise by increased regulation and enforced capital requirements we could see increased activity in the capital markets risk transfer space as re/insurers look to it for supporting capacity. As cat bond and ILS pricing is driven to some extent by investor appetite and the availability of capital in the sector, this could lead securitization pricing to become even less correlated with reinsurance pricing, at least while the market adjusts to the new regulatory environment.

Of course this is speculation but it is going to be interesting to watch how the markets, insurance, reinsurance and the convergence sector, adapt to the new regulations, solve their capital adequacy and requirement needs and how big a role the capital market sources of capacity have in resolving and stabilising things. We feel it is likely that the capital markets will have a larger role to play than many expect, be that in provision of collateralised reinsurance or cat bond and ILS capacity and this further heightened interest could serve to give catastrophe bonds an edge. As ever your thoughts are welcome in the comments below.