UK City regulator to speak out on ILS and catastrophe bond risks: FT

by Artemis on September 30, 2013

The UK’s city regulator, the Prudential Regulation Authority, is set to speak out about perceived risks created by the influx of alternative capital into the reinsurance market through insurance-linked securities (ILS) and catastrophe bonds, according to the Financial Times.

Update: Details of Julian Adams speech on October 2nd can be found here.

The Prudential Regulation Authority (or PRA) is the UK’s City regulator and is tasked with the regulation and supervision of UK financial services including insurance and reinsurance. As we wrote two weeks ago here, it has been reported that the PRA is taking a keen interest in the current growth of alternative reinsurance capital, which sees third-party investors backing reinsurance contracts and instruments such as catastrophe bonds.

Now, according to a news story published yesterday in the FT, the regulator is preparing itself to discuss the issues it sees in ILS and cat bonds at a speech being made on Wednesday. Julian Adams, executive director of insurance at the PRA, is due to speak to the Lloyd’s of London insurance and reinsurance market this week and apparently ILS, cat bonds and alternative capital is on the agenda.

The FT said that it understands that Julian Adams will question the viability of traditional insurance business models in the face of change brought on by alternative capital. That we cannot disagree with and regular readers will be aware that the market is changing as reinsurers and also insurers work out how best to embrace and accommodate third-party capital within their businesses.

The FT also says that the PRA is ‘assessing the quality of the collateral’ in catastrophe bond deals. This is more interesting, as with catastrophe bonds being fully collateralized and the collateral assets held in trust while invested in treasuries, it is hard to see how a regulator could object to that.

There are areas of collateralisation of risk in reinsurance that do warrant some investigation, but the cat bond market and fully-collateralized reinsurance contracts would perhaps be a peculiar area for the regulator to focus on. It will be interesting to see whether the FT is right and this is raised as an issue, or whether it is another area of collateral that it seeks to question.

More generally, the PRA has apparently identified the interest of alternative capital in reinsurance as one of its top priority issues facing the insurance and reinsurance industry. Adams is set to highlight the risk to specialist insurers, according to the FT, who may be forced to diversify into new lines of business without the underwriting expertise to back it up.

It will be interesting to see what is raised in this speech. If we had to guess, we would imagine that Julian Adams will highlight the inflow of capital as requiring regulatory oversight to ensure that underwriting standards are adhered to. If he does raise issues about collateralisation we can only think it will be for specific types of collateral, perhaps parental guarantees which have received attention before, not full-collateral arrangements.

As always, it is useful to the market to have regulators come forwards to engage with market participants to discuss any potential for issues arising. This enables the market to keep on top of any risks and helps market participants to educate the regulators to ensure they can focus on the right areas.

Regulation is never a bad thing, however misguided regulation can be detrimental to a markets progress. The ILS and cat bond market, as well as other alternative reinsurance capital vehicles, need to engage with regulators around the globe to ensure that they are able to work with the market to help it become a sustainable form of risk transfer and a sustainable asset class for the interested third-party investors.

It is also worth reiterating that as the alternative reinsurance capital, ILS and cat bond market grows, interest from regulators as well as general noise in the more mainstream financial press will increase. This is a sign that the ILS market is growing in importance as it contributes an ever greater share of global reinsurance premium capacity.

We will update you once the content of the speech is revealed later this week.

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