UK regulator to monitor alternative reinsurance capital trend

by Artemis on October 2, 2013

Julian Adams, the Deputy Head and Insurance Director of the Bank of England’s Prudential Regulation Authority (PRA) spoke to the Lloyd’s of London insurance market today and discussed the regulator’s approach to supervision of insurance and in particular the alternative reinsurance capital trend.

The speech by Adams was very well attended at Lloyd’s as reports earlier this week had already suggested that alternative capital and its impact on the reinsurance market would be a key theme. Those reports were correct and Adams used alternative reinsurance capital as a currently high-profile example he could use to explain the regulators approach to supervision of insurance and reinsurance.

The speech aimed to explain the Bank of England’s new supervisory remit for the insurance and reinsurance market, with particular focus on London and Lloyd’s. The PRA now contains a single insurance directorate with two arms, one focused on life and the other on general insurance and reinsurance.

Adams said that the regulator was keen to draw on experience gained from the recent financial crisis to help it be a more proactive regulator, with a focus on risks that may arise in the future. Adams said that as regulators they are ‘professional pessimists’, have to make judgements about what might happen, look at potential future scenarios and would seek to be a forward-looking regulator, rather than a purely reactive regulator.

To be an effective regulator Adams said that the PRA needed to understand firms business models, how they make money, the sustainability of models over the longer term and the capital required to underpin it. He said that the regulator does not want to stand in the way of change, but rather wants to ensure that change happens in a sustainable manner and without any build-up of risk. The potential for a build-up of a risk or systemic interconnectedness is an area of key focus for the PRA.

Adams was keen to stress that as a regulator it is not the PRA’s job to stop firms failing or to prevent or protect incumbents from new competition, rather it is the PRA’s job to ensure that if firms do fail they fail in such a way as not to increase risk marketwide, so being able to fail safely.

With the background of the PRA’s approach to supervision out of the way, Adams moved on to discuss alternative capital. He chose the recent trend for alternative capital to flow into the reinsurance market as one to illustrate the PRA’s approach because it is a hot topic and he felt it would resonate with the audience. He stressed that he could have chosen other topics, but felt that alternative reinsurance capital was a topic that the London market would be interested to hear the regulators thinking on.

He discussed the increased interest that institutional investors have shown in reinsurance and the rapid inflow of new capital into the sector in recent years, but stressed that it is important not to overstate these developments as the structures used by alternative capital have been used for almost twenty years in the market.

Adams said that it remains to be seen whether the inflow of alternative capital into the insurance and reinsurance market will create a structural shift in business models or whether investor interest might wane when financial markets pick up or it is tested by losses. But the fact that this is creating concern among some traditional reinsurer incumbents, and that the regulator looks ahead to envision what may happen, makes alternative capital a topic it will be monitoring.

The PRA does not regulate the alternative capital providers themselves, Adams said. He explained that investors need to satisfy themselves with the appropriateness of decisions taken with their capital, saying; “This is definitely an area in which investors need to satisfy themselves that they understand the risks they are taking on before investing.”

Adams continued; “whilst the investor base currently appears to be overwhelmingly professional, I know there has also been some commentary about whether these structures might eventually feed through into funds available for retail investors. Nor do we supervise the brokers who clearly exercise an important role in this market in facilitating the placement of risks between insurer and insured. These issues are matters firmly for our counterparts at the conduct regulator – the Financial Conduct Authority.”

However, Adams said that the PRA’s interest in alternative capital lies in the fact that the availability of this capital has direct bearing on the decisions made by insurers and reinsurers underwriting and pricing risk and on the sustainability of their business models and lines of business.

So it is the effects of alternative capital on the market, rather than alternative capital itself, that the regulator seems set to focus on. This is perfectly understandable and it would be remiss if the key financial services regulator in the UK was not keeping a close eye on the insurance and reinsurance market as it enters a period of potential change and shifting business models.

Adams highlighted some key questions and issues that he said the supervisor will ask regarding alternative reinsurance capital. We repeat these below in full from the speech transcript for your interest:

To start with – what work have firms done to think through how these trends might impact on key business lines which could impact over time on their existing business models and the implications that might have for their strategies or risk profiles? For example, could the pricing pressure in cat markets prompt reinsurers to refocus on other lines, or to less well-modelled areas of cat risk? If so, might this cause firms’ business mix to become more concentrated/specialised and if that is the case, how would this affect the level of diversification assumed for business purposes and indeed capital modelling purposes?

Next – what assumptions are firms making about the lines which are likely to be relatively more or less affected by these trends? Again we must be careful not to exaggerate the impact of alternative capital. To date, the direct effects have been concentrated in the North American property cat area. And even within that line of business, we have seen differential effects with alternative capital providers seemingly preferring to operate at the higher layers, possibly leaving more room for more traditional reinsurers to operate lower down the programmes. But it is possible that over time, investor appetite might increase further down the layers of a cat programme, or broaden into other geographies or classes of business.

Then – what could these trends mean for the long-term rate of return that insurers might be able to generate on their core underwriting activity, given that new capital providers are often able to operate at a lower cost of equity than traditional insurers? How do these firms respond to reconcile the return historically demanded by equity providers, with the business need to maintain a high A rating to operate within the market and at the same time maintain underwriting and reserving discipline?

Then – to what extent might firms need to diversify by developing their own capital markets divisions or vehicles to attract and/or manage capital from other investors, and what implications does this have? Such a move could help firms preserve their strategic options, but will change the dynamics of the overall business to some extent, for example by changing the overall mix of earnings to include more fee-type income – this might be a more stable earnings stream, but might generate a lower return on equity. We will want to know how firms manage such a transition, and ensure their incentive structures are appropriately aligned with underwriting of risk.

Where insurers look to take advantage of capital provided by these structures to help them manage and mitigate their own risks, we will want to know how well they understand the terms and conditions attached to the structures, and the extent to which risk is actually transferred. We would expect firms to have a particularly good understanding of this. Some of these structures may introduce basis risk, for example, between the risks insured and the protection purchased. And some of these structures do not offer the same sort of reinstatement cover as traditional reinsurance. Where firms look to include alternative mechanisms alongside traditional reinsurance programmes, we will be interested to understand how the overall programme works in its entirety and in particular how losses might be traced through the programme.

We expect firms to analyse carefully the collateral arrangements which form part of these deals, to ensure that they are satisfied that cover will respond in all the circumstances that the insurer expects and that they understand whether there are any circumstances in which collateral may be insufficient or possibly withdrawn. And it may be that the collateral mechanisms in these structures may need to adapt further if investor appetite changes. For example, collateral arrangements may need to respond differently if investor appetite moves away from a focus on the top layers of catastrophe cover, to lower layers where they might be more exposed to attritional losses.

Where insurers delegate underwriting decisions to others, they must continue to monitor and oversee the aggregate risks to which they are exposed to an appropriate level, to understand the implications for the overall profile of the business they write – and be able to demonstrate this to us. This issue is not a new one to the market but some of the recent developments underline its importance. It is also important that all those individuals who make decisions affecting UK insurers are captured by our approved persons regime.

With margins under pressure, we will want to know the extent that firms are looking to adjust their cost base and what additional risks this might pose. For example, how these developments are affecting firms’ assessments of the minimum viable size needed to compete in the market. We see some participants arguing that a rational strategic response to these developments is to seek consolidation, particularly amongst the smaller players. This might help if a firm’s sole limiting factor is one of the scale needed to compete and there are synergy benefits of combining two businesses. However, firms need to be careful that there is an underlying business logic to such deals beyond cost reduction. If there are similar underlying issues with the viability of two firms’ business models or financial performance, creating a larger combined business will not necessarily address these structural issues.

These all appear sensible and prudent questions regarding the future health of the insurance and reinsurance market as it adapts to one increasingly utilising alternative capital within its underwriting business. Encouragingly Adams was keen to stress that the regulator is not here to stifle innovation, prevent competition, save traditional business models or to disrupt what it sees as natural market forces and a natural market evolution.

At a wider macro level, Adams said he had two points to make. The first was on opportunity, the London re/insurance market is well positioned to be a leader in utilising alternative capital to expand and grow the penetration of insurance and reinsurance worldwide.

Secondly, Adams spoke on the potential for a build-up of system-wide risk. As a regulator it is important that it investigates and monitors any potential for system wide risk, said Adams. He said the regulator would focus on the extent to which insurers and reinsurers are taking on leverage, in terms of the amount of capital backing each unit of exposure.

Adams explained; “We will be looking to assess, at a system-wide level, the extent to which these structures are enabling the system to reduce the overall level of capital backing a given level of catastrophe exposure, the extent to which line sizes are increasing, and the impact this might have on cat aggregates both in absolute and regional terms over time and the average rate on line firms are able to achieve.”

Again, that sounds eminently sensible and exactly the sort of supervision that the insurance-linked securities (ILS) and alternative reinsurance capital market players should welcome and engage with. Engagement is particularly of importance as regulators themselves do require educating at times and that is the job of the market participants in any emerging, rapid growth sector like ILS and alternative capital.

Adams stressed that the regulator does not see any of the issues or questions he raised as insurmountable. Rather they are trends which pose questions for incumbent insurers and reinsurers, and the regulator is keen to understand their views and approaches to answering them.

So the regulator was not today raising a case for regulating or supervising the alternative reinsurance capital and ILS space. Rather it was setting out its approach to regulation, using alternative capital as a great example and in the process raising some very pertinent issues which it would be expected that a regulator of financial services would be aware of and choose to monitor.

In questioning, one listener asked Adams whether the regulator might choose to throttle the access of capital into the market to protect traditional insurers and reinsurers?

Adams was keen to explain that as a regulator it is not their job to protect incumbents. In fact, Adams said that if people want to enter the market then they will be assessed on their own merits, not the impact they may have on others. The influx of capital from new entrants (such as ILS and alternative capital) may exert effects on the traditional market, but Adams said these are market effects and so not a regulators job to stop it. He again stressed that as a regulator the PRA has a responsibility to ensure that company failures occur in a safe manner, not to prevent those failures.

So, the upshot of this speech was that the regulator made the London market aware of its approach to regulation and that alternative capital is firmly on its radar and that it would be monitoring the trend. The Bank of England and the Prudential Regulation Authority will look at any risks that arise from firms using or impacted by alternative capitals march into reinsurance. The question is, would have expected anything less from a regulator?

You can access Julian Adams full speech via the Bank of England website here.

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