ILS market to double by 2018, drive further rate decreases: Credit Suisse analysts

The insurance-linked securities (ILS) and alternative reinsurance capital market is expected to double in size by 2018 as additional capital flows into reinsurance looking for a source of investment returns with low-correlation to wider financial markets, say analysts at Credit Suisse.

In a recently published research report, Credit Suisse equity research analysts Michael Zaremski and Crystal Lu make a base-case forecast for the growth of the ILS market and say it is likely to double over the next five years. With ILS and alternative capital contributing around $45 billion of the global reinsurance market right now, the analysts expect another $40+ billion of capital to enter the market.

As a base case projection this is very reasonable, when compared to other forecasts which suggest that as much as another $100 billion of third-party capital could enter the ILS and reinsurance market over the coming years. It’s possible that reports in early 2014 will say that the ILS and alternative, or collateralized, reinsurance capital market may have grown to $50 billion or $60 billion after the January renewals, so aiming for a doubling by 2018 seems a very achievable forecast.

Of course the case for growth in ILS and alternative reinsurance capital opportunities is largely linked to the markets expansion, either into new catastrophe reinsurance regions or new lines of business. The analysts at Credit Suisse say that the ILS asset class is likely to make inroads into other reinsurance lines as part of this forecast for growth over the next few years.

The report says that peak catastrophe risks are capital-intensive on either rated or leveraged balance sheets, but better for third-party capital balance sheets, making the case for ILS stronger. At the same time ILS issuers appreciate the elimination of counterparty credit risk within an ILS structure enabling them to avoid large impacts to equity balance sheets when large catastrophe losses occur.

The analysts estimate that as the ILS market has 30% to 40% penetration of peak catastrophe risk markets, while 50% of the ILS market is creating new demand rather than taking market share from traditional reinsurers, means that if another $40 billion came into the market it would only remove around $1.4 billion (the analysts assume a 7% rate-on-line on $20 billion) of traditional capacity.

This is interesting as it makes the case for reinsurers branching out into third-party capital. If they are only cannibalising a small amount of their business, but adding additional opportunities using very low-cost capital (compared to equity) the reinsurer capital market unit looks a sensible response to recent trends.

Further pricing declines are likely, as additional capital comes into reinsurance, but some of the decline in revenue at reinsurers would likely be offset by capital management fees and profit-sharing from their third-party capital ventures. The analysts note that this will not be enough to offset the overall reinsurance pricing declines that they expect in 2014 and they estimate a further 10% to 15% decline in U.S. property catastrophe reinsurance pricing upon the coming January renewals.

The report highlights reinsurance lines such as aviation and marine as possible areas for ILS firms to offer differentiated products. However they note that expansion into these lines may not be as easy as moving into property cat, as these lines are much less capital-intensive on a rated balance sheet.

As a base forecast there is room for the market to grow faster than this. A number of issues could stimulate further rapid growth in ILS and alternative capital, such as the privatisation of U.S. flood insurance, greater use of reinsurance in Florida as Citizens depopulates, growth in use of earthquake insurance cover which would require reinsurance, or the launch of trusted risk models in new peak catastrophe zones, for example.

The one factor that could stimulate further rapid growth, or potentially a contraction, of the ILS market is of course a large catastrophe event in a core reinsurance market. It’s difficult to predict which way the market will go after the next large catastrophe loss, a lot hanging on the type of event and how expected it is for investors.

A large, but well-modelled and generally expected catastrophe loss could result in a doubling of the market in a much shorter period of time, if the rates and capital deployment opportunities became available. Conversely, a large but largely unexpected loss to ILS investors could trigger a withdrawal of some capital. The second, unexpected, scenario would also show any gaps between managers of ILS capital, as those who had been less transparent about the potential for losses would likely lose more capital.