ILS market has a long way to go before it can realise its full potential: PwC

by Artemis on September 18, 2012

The insurance-linked securities and catastrophe bond market has been going from strength to strength in the last twelve months. We often write about the successes of the market, the growth that is being experienced and the burgeoning interest from both potential sponsors and return-seeking investors. The market seems very healthy but as well as cheerleading the sector it’s important to look at what it might take to help the ILS and cat bond market elevate itself to the next level.

A recent report published by the PwC insurance and reinsurance team contains some interesting insights into the market and poses some pertinent questions which point at where the market may need to focus in order to achieve the next level of growth. The report titled ‘Unlocking the potential of ILS’ assesses the scope for growth and expansion in ILS and cat bonds, and looks at ways to overcome the barriers to convergence within the ILS market. It suggests ways to overcome the fundamental challenges that growing a market like ILS presents and how the instruments, as both risk transfer tools and investment assets, can be taken into the mainstream.

The ILS and cat bond market is not yet 2o years old and yet it has grown to the point where the ILS market now provides as much as 14% of global catastrophe reinsurance capacity, according to PwC analysis. So in a short lifetime the ILS market has got to a point where it is contributing a very meaningful percentage of reinsurance capacity for catastrophe risks around the globe, which PwC say is remarkable considering the reinsurance market itself is around 700 years old.

After such stunning growth it is easy to get carried away and feel like the market is destined to continue taking over traditional reinsurance share, but PwC urge caution, saying that while firmly accepted as a complementary alternative to reinsurance, ILS has a way to go before it can realise its full potential.

The opportunity for ILS and cat bonds, as well as the other forms of alternative reinsurance which come under the ILS banner such as sidecars, collateralized reinsurance and industry loss warrants (ILW), is clear though, according to PwC. Increasing global economic development alongside growing catastrophe risk (or at least the growing awareness to developing world catastrophe risk) is a telling indicator offering just one example of where and how ILS could come of age.

PwC cite the example of the flooding in Thailand and the unexpectedly large insured losses that the catastrophe event resulted in. PwC says in the report that ILS could play a crucial role in addressing just these kind of risks in these types of developing economic regions of the world. The world is currently experiencing a changing global risk landscape, with exposures rising as countries develop, supply chain risks increasing and environmental factors appear to be making catastrophe events more frequent in some regions. This perfect storm of growing exposure and growing risk presents a timely opportunity to the ILS market which could capitalise on these factors. By simplifying risk transfer, providing much needed loss absorbing capacity, attracting new sources of risk capital and offering an efficient way to match risk, capital and reward, PwC says that ILS could be the answer to catastrophe coverage in examples such as this.

The ILS and cat bond market has some work to do before it can truly hope to expand into these new risks and territories, and a number of barriers need to be removed before ILS can reach its full potential, says the report. The key is in demystifying ILS as a risk transfer tool and asset class, and sponsors need to work with market participants to remove complexity, increase understanding of how the structures work, improve the transparency of the underlying risks and how those risks match up to the potential rewards or returns that the asset class offers.

The report highlights a number of areas that the market could focus on with a view to achieving greater growth, according to PwC who said in the report that if market participants tackle the challenges highlighted then we could begin to see the critical mass of trading liquidity that would help ILS become more mainstream.

There are opportunities to innovate using technology to help improve risk modelling and analytics. With greater transparency and better analytics pricing could be more effectively linked to ILS risk profile and the structures themselves could be finely tuned to match them with investors appetites for risk. This could also help to pave the way for product transparency and standardisation which could in turn lead to greater liquidity and attract new investment capital.

PwC make an interesting point on the potential to adjust hedging information as new data becomes available. The report mentions the potential for the use of sensors to transmit data and information and how this could be used in risk transfer, including in ILS. This kind of innovation is key within the ILS market and could make the difference between ILS and cat bonds being the domain of large sponsors and the ability for the instruments to trickle down to smaller sponsors as real-time sensors and data could enable large cost-savings to be passed on. We actually hinted at this in this article where we discussed research that has been looking into automated parametric triggers which would be sensor based, we’ve also read a number of patent applications on this topic so here PwC could be onto something.

PwC pose some questions for the market which we feel are worth repeating here so our readers can respond if they want to in the comments below. We’d love to hear your thoughts.

These questions are for market participants to consider when thinking about ways to help the ILS market grow:

  • Where are the growth opportunities in ILS (e.g. location and risk type)?
  • Do your risk evaluations take account of the rapid changes in the risk landscape and how can you bring your analytics up to speed?
  • How will your products need to develop to meet changing customer expectations?
  • What new sources of capital could you reach into (e.g. emerging market investors) and how can you align your products with the differing risk appetites and investment strategies?

The report contains other interesting questions and points to ponder which we encourage you to read. PwC also details some of the key issues that it feels the market needs to address or at least be considering if it is to continue growing.

The top six barriers to growth according to PwC are:

  1. The need for better risk insights
  2. Simpler and more understandable products
  3. Managing down risk
  4. Reducing cost and complexity through standardization
  5. Factoring in capital market risk
  6. More consistent rating

Even if the market cannot easily answer the above questions right now, or see clear ways to address the six barriers to growth that PwC highlights, it is important for us to begin considering them. PwC give some great insight into each of the barriers and pose more questions in their report.

We spoke with Arthur Wightman, Partner and Bermuda Insurance Leader at PwC, to get some additional insight into the market. We asked Arthur what he felt had been driving the success of the market to date and where he saw the potential for market expansion and growth, to which he responded;

“The uptick in non-traditional capital participation over the last 6 to 18 months in  property catastrophe reinsurance sector has been impressive. Arguably there has been a perfect confluence of factors including tightening prices, greater clarity and liquidity, above average yields, broader selection of vehicles to choose to invest in or off-load risk to and a reformed buyers’ perspective that is more comfortable in blending traditional and non-traditional programmes. This has all led to broader acceptance that convergence in this marketplace is permanent and complementary to traditional reinsurance product. This has been further enhanced by jurisdictional centres of excellence emerging, not just from an innovation standpoint but also in terms of providing a convergence environment (investor and sponsor marketplaces) facilitating transactions that are now faster, cleaner and more cost effective. Bermuda is at the forefront of this.”

“When you look at the big picture, impressive though the growth of ILS in the  property catastrophe reinsurance sector is, it remains at 14%, which in turn is a far smaller percentage of the broader reinsurance market overall. When you put that up against the expected growth in reinsurance demand overall, particularly driven by the rapidly expanding markets of South America, Asia, Africa and the Middle East, it provides a glimpse at both the challenges the ILS segment has in converging across the entire  reinsurance landscape, but perhaps more poignantly, the opportunity. Unlocking the potential of ILS examines some of these potential barriers and points to some possible solutions”.

It’s key for the growth of the ILS market as a viable alternative to traditional reinsurance and risk transfer that the market keeps innovating and looking to opportunities to expand. In this report, PwC highlight some of the important questions that market participants need to consider and suggest some areas where focus should be placed.

You can access the full report from PwC via their website here.

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