Canadian regulator on lookout for yield hunting reinsurance investors

A few days after it was reported that the UK’s leading City regulator is monitoring the influx of alternative capital into the reinsurance market, the top Canadian financial regulator has stated the importance of ensuring that third-party investors are not purely accessing reinsurance in a search for yield.

Julie Dickson, head of the top financial services and insurance regulator in Canada the Office of the Superintendent of Financial Institutions Canada (OSFI), spoke yesterday at the National Insurance Conference of Canada. Dickson has clearly noticed the recent increase in coverage of the alternative reinsurance capital trend and it featured prominently in her speech.

Dickson’s speech began by discussing the increasing nature of insured catastrophe losses in Canada, something the country has seen plenty of in 2013, as well as discussing unmodelled risks and the importance of reinsurance protection for the countries insurers. This led her onto catastrophe bonds which she sees as positive additions to the insurers risk transfer toolkit.

“Given that catastrophic risk seems to be growing, going forward we may also see insurers more actively expanding risk transfer mechanisms through Insurance Linked Securities (ILS). Catastrophe bonds can be used to help companies to reduce exposure to certain risks, including earthquakes. Cat bonds are an effective way to transfer risk to capital markets, instead of reinsurance markets, and to spread risks. At the same time, they do not eliminate all risk. For example, basis risk, where the trigger for a claim might not be directly matched to the losses of the insurer, could result in the insurer experiencing losses with no protection. From a capital perspective, if the link is not one-for-one with the expected losses, there is no capital benefit. But such catastrophe bonds can be a good addition to an insurer’s risk management program.”

Dickson then highlighted the need for investors to understand the risks they are allocating capital to, focusing on the need for those responsible for deploying capital to truly understand the portfolio of risks that capital is designed to support.

“While issuance of catastrophe bonds may be a good addition to a company’s risk management tools, investments in catastrophe bonds could present risks to investors, particularly if the investments are being made in a search for yield, without regard to an understanding of the risks involved.”

Dickson then moved on to discuss the recent growth of alternative capital, from the capital markets and institutional investors, in the reinsurance market. She cited concerns about “Too much capital from institutional investors entering the insurance system” and referred directly to the FT article about Lloyd’s chairman John Nelson’s comments regarding systemic risk (our article on that can be found here and a follow-up here).

“Another example of search for yield, which has recently been expressed in international circles, is concern about too much capital from institutional investors (such as pension funds) entering the insurance system in search of yield. Such excess funding or capital can put downward pressure on premium rates, and assuming those rates were properly reflective of risk, this is not what should be happening (for example, where the increased severity and frequency of actual catastrophe risk is on the rise).”

Finally, Dickson suggested that the regulator will be keeping a close eye on the alternative capital inflows in the reinsurance market to ensure that underwriting standards are maintained and there is no evidence of capital being deployed without an understanding of the underlying risks.

“While we have not seen similar behaviours in Canada thus far, it is important to continue to be on the lookout for any evidence of a search for yield and unintended consequences.”

The increased discussion and suggestions of surveillance of the insurance-linked securities (ILS) market and third-party reinsurance capital is a natural occurrence when a market reaches a size where it garners an increased level of attention. ILS and alternative capital in reinsurance seems to have reached that tipping point, with the focus on these topics at Monte Carlo this year further evidence.

For years alternative capital has been supporting catastrophe bonds, ILS and other collateralized reinsurance contracts, Artemis has been focused on this for over 14 years now. For even longer, third-party capital has been supporting Lloyd’s syndicates in their underwriting of insurance and reinsurance business. The recent increase in publicity, coverage and general media noise about alternative capital is a sign that the market has grown its profile to a point where regulators are taking more notice.

Of course, the trigger for this increased focus and attention on alternative capital just so happens to have been the reductions in reinsurance pricing at recent renewals. Some seem to have forgotten that reinsurers are themselves over-capitalised and that alternative reinsurance capital makes up a small portion of the reinsurance market. Lack of large catastrophe losses also seems to have been overlooked, with commentators preferring to focus on the inflows of alternative capital and the potential for underwriting standards to be reduced.

Here we feel it worth repeating this line from an article published last week:

All sides of this transforming market are going to have to maintain diligence, standards and remain focused on accurately pricing and underwriting risk at whatever their new cost-of-capital ends up at post-convergence.

Just because the cost-of-capital comes down doesn’t necessarily mean that underwriting standards will be reduced. In fact, as we’ve said many times, the vast majority of ILS investment managers and institutional investors like pension funds who allocate capital to reinsurance, display extremely strong underwriting standards and a keen appreciation for the importance of accurately pricing risk.

That said, it does not hurt for the regulators to keep an eye on the space to ensure standards are adhered to, in the same way that they do with traditional reinsurers. Keeping a lookout for yield hunters in the reinsurance and ILS market will push the market to keep best practice at the heart of everything it does, which will in turn help it to grow sustainably into the future.