Insurance-linked securities market calling for innovators: PwC

The insurance-linked securities market is calling for innovators and ‘fast followers’ to drive the sector’s growth forwards, according to a new report from PwC. Innovators will seek out new opportunities for ILS in order to grow the market and the alternative reinsurance capacity it provides.

PwC’s new report, titled ‘Expanding the potential of ILS‘, follows on from a report published last year ‘Unlocking the potential of ILS‘, and discusses the need for the ILS market to find new avenues for growth in order to find profitable opportunities without the need to compete ever more fiercely with traditional reinsurance.

It’s vital, said PwC, that as ILS and alternative reinsurance markets evolve, they maintain or develop shareholder, policyholder and counterparty value over the longer term. This is a key point that perhaps the ILS market has been in too much of a rush to really focus on, but PwC believes it is time to look at how to make ILS a long-term, sustainable alternative and complement to traditional reinsurance.

In the last 12 months the aggregate capacity share of the reinsurance market held by ILS alternatives has only grown by 1%, according to PwC, but structural changes and innovation along with some dislocation are likely to lead to a permanent shift in the market. Such change brings opportunity and innovators as well as ‘fast followers’ stand well positioned to reap the benefits.

Rather than increasingly trying to compete more fiercely with reinsurers, ILS innovators need to look outside of the traditional avenues it has plied its trade to date. Innovation could help the ILS market to grow even more rapidly, said PwC, enabling it to keep up the impressive growth seen in recent years, which PwC believes amounts to $30 billion of new alternative capacity in just three years.

An example of innovation in recent years is the growth of the unrated catastrophe bond space, made up of privately transacted catastrophe risk securities, has grown by around 50% in the last two years and now makes up around a third of the market. This shows sponsors and deal makers reacting to investor demand for catastrophe risk as well as finding ways to make issuance easier and more cost-effective.

These changes and convergences in the ILS market show that the barriers to entry of the ILS market are softening. However, PwC’s report suggests that as barriers come down new entrants and investors increase the risk of market dislocation, which could lead to structural shifts in the market.

Arthur Wightman, partner, PwC Bermuda, commented; “The rules around risk transfer and risk financing are being re-written as the convergence market finds a way through many of the structural barriers to entry, and new investors crave return from this uncorrelated asset class. Risk managers and sponsors are finding enhanced ways to hedge their programmes; however, aggregate capacity has not shown net growth. The market is calling for innovators – these will be participants who can embrace current market dynamics profitably while defining new avenues of demand at significantly better-than-average returns.”

The PwC report takes a refreshing viewpoint and does not focus on driving down prices, costs or competing heavily with reinsurance. Rather it attempts to set out a path for the ILS market where it innovates heavily, creating new avenues of opportunity for itself, be that in new structural features, new lines of business, new territories or by becoming ever more complementary to traditional covers.

PwC make an excellent point here. The last thing the ILS market needs is to kickstart a race to the bottom with reinsurers. The ILS market has never professed a desire to replace reinsurers entirely, rather to ensure that third-party capital plays its role in the market in the areas it is most appropriate.

Of course the end result may be that reinsurers become managers of alternative and third-party capital, but that would leave the dedicated ILS specialists to continue to provide the kind of peak coverage it is so suited to. With innovation perhaps being easier in small, lean, ILS focused specialists than large reinsurers, perhaps traditional reinsurers should support ILS market growth via new and innovative ventures.

Wightman added; “As always pricing adequacy and risk selection are paramount particularly in segments of the market where there is very aggressive competition for existing and finite capacity. Risk mitigation is a long term proposition and it is this principle that must remain core as the market evolves further.”

The PwC report also looks at how traditional reinsurers can create opportunity from ILS and that a growing ILS market may actually be a good thing for traditional reinsurers.

The report suggests that a collaborative approach is the best way for reinsurers to access opportunities, through combined solutions and strategic partnerships with sponsors or traditional providers. New ways to open up areas of growth are suggested in the report as graphic diversification, product innovation, customer-centric approaches to risk transfer, simplification and transparency, and data and analytical advances. All areas that large traditional reinsurers can excel.

Bryan Joseph, partner, global actuarial leader, PwC, commented on the opportunities for reinsurers; “The growth in investment in ILS is creating an opportunity for traditional reinsurers and for the new ILS funds to participate in new markets and risks. To obtain growth and achieve the desired yields, investors will have to embrace new types of risks where there is less data and advanced modelling available. Areas such as pandemic risk and terrorism risk are concrete examples where the capital markets may be best placed to assume some part of these risk types.”

And a growing ILS market, which pushes traditional reinsurers to innovate and seek new opportunities, may in turn result in new markets that ILS and alternative capacity can tap in the future. The key is for reinsurers and ILS specialists to position themselves as innovators and be willing to adapt to the changing market dynamics.

Joseph continued; “The wave of new capacity in the sector will push the traditional markets to diversify into more specialty business and also by geography into the new areas in Asia, South America and Africa.  At the end we will see growth in the market rather than cannibalisation of existing markets. With more than $3 billion of new capacity coming to the ILS market in the first half of 2013, we are experiencing transformational change and the winners are those who adapt and evolve under the new conditions.”

It’s not just reinsurers that need to be willing to adapt and evolve, brokers too are facing change but also great opportunity, according to Richard Mayock, partner and global insurance brokerage sector leader at PwC, who said; “Increasing demand for ILS has created an opportunity that brokers are uniquely positioned to exploit. In the coming 2 – 3 years, we see a scenario where brokers leverage three of their strategic assets – deep data-driven market insights, global customer relationships, and knowledge of public and private emerging risk concerns – to assist with the development of a stream of new ILS products and market them through a broker-led exchange specifically focused on economical risk mitigation.”

With the ILS market having a stellar year in 2013, and interest from third-party investors in the ILS and alternative reinsurance space at an all time high, it is perhaps a good point to step back and consider how to move the market forwards in a sustainable fashion.

The report from PwC does this well, discussing emerging ILS market trends, raising a number of key issues and making suggestions for how the market can move forwards responsibly and grow.

Geographic diversification, product innovation and new perils and capacity are all key to a growing ILS market, but equally important is making sure there is a customer focus, transparency and benchmarking of models while at the same time pushing back frontiers to expand the market.

The ILS market needs to work to expand in a sustainable and responsible manner, without sacrificing fundamentals of appropriate risk selection and pricing adequacy. This makes market discipline key at this important point for the ILS sector and PwC believes that those who embrace this time of change and innovate responsibly will thrive.

The full report can be downloaded from the PwC website: ‘Expanding the potential of ILS‘.