EIOPA highlights concerns on ILS and catastrophe bonds

You know a sector is gaining traction, experiencing growth, rising in profile and becoming more mainstream when the regulators express an interest. In 2013 it has been the turn of insurance-linked securities (ILS), catastrophe bonds and alternative reinsurance capital.

This year we’ve seen a number of regulators express an interest in and concerns about the strong growth of the ILS, cat bond and alternative reinsurance capital market. Regulators have seen the markets growth accelerate, with third-party capital inflows into reinsurance at an all time high and the cat bond market in its second strongest year ever, which has increased the level of scrutiny the market receives.

The latest regulator to express concerns about the rapid growth of the ILS and cat bond market is the European Insurance and Occupational Pensions Authority (EIOPA). In the EIOPA’s latest half-year Financial Stability Report it says that; “The strong flow of new capital into insurance-linked securities (ILS) is also causing some concerns and need to be monitored.”

EIOPA notes that reinsurer capital levels are at an all-time high, partly assisted by the flows of capital into the ILS space. The regulator notes that the ILS space has reached its highest levels of issuance and outstanding since 2007 thanks to large capital inflows across the reinsurance sector.

It’s worth noting that the ILS space is actually at the highest level of risk capital outstanding ever, it is only issuance in 2013 that is secondary to 2007.

EIOPA says in the report that the strong flow of capital into ILS and catastrophe bonds raises some concerns. This significant change in the market has been driven by subdued economic growth and a low yield environment driving investors to look for ‘safe investments uncorrelated with other assets’.

EIOPA says that one concern is that new capital inflows into ILS and cat bonds mostly originate from fixed income investors, such as pension funds, who are searching for yield. The regulator is concerned that not all of these investors have the necessary modelling and analytical capabilities to fully understand the underlying risks and complexity of the insurance market.

The EIOPA report says; “Without adequate supervision, such developments could cause systemic risk.”

These comments are very similar to those made earlier this year by the UK’s Prudential Regulatory Authority, which said it would monitor the progress of the ILS market. We’ve also seen other regulators (the IAIS) say that ILS and alternative reinsurance capital would be factors they consider in their decisions over whether insurers and reinsurers are systemically risky. The Canadian regulator say it would look out for ‘yield hunting investors’. We even saw the Lloyd’s chairman call ILS systemically risky in 2013.

EIOPA also noted that the growth of ILS capital in the reinsurance market is making for an increasingly competitive environment, resulting in price reductions across property catastrophe risks.

Finally the regulator warned that the developing ILS market needs to be closely watched by regulators as extensive usage of ILS can cloud the picture in terms of understanding the risk transfer. It’s easy to see why this concern arises for regulators, however it could just as easily be levelled at some forms of traditional reinsurance where the underlying risks are not as apparent as in primary insurance.

EIOPA has clearly been listening and finds the growth of the ILS, cat bond and alternative reinsurance capital market warrants closer attention. This is no bad thing, any growing market deserves supervision especially if it can be proactive in its intervention should it see any undue risks emerging.

The fact that regulators are increasingly interested in ILS shows that the market is growing in importance. Therefore it is important that market participants remain aware of this and work to promote transparency, educate their investors and ensure no undue risks arise from the business they undertake.

Regulators will regulate and supervisors will supervise, we would expect no less from entities such as EIOPA, the PRA and IAIS. As the ILS and alternative reinsurance capital market continues to grow, develop and becomes an increasingly important piece of the insurance and reinsurance puzzle, it makes sense that financial regulators look out for any market risks which could emerge.

One important note; we’ve reached out to a number of large ILS investors and capital managers this morning and not one has ever spoken with EIOPA about their concerns. We feel it is important to engage regulators and to help to educate them on the market, the investor base and its sophistication and on this topic of systemic riskiness. Market participants are best placed to provide this education and the ILS market is now at a size where discussion with regulators is likely warranted.

EIOPA will continue to observe the ILS space as it develops; “Although the ILS market is still a niche in comparison with the overall securities market and small in comparison with the overall reinsurance market, it is of significant size in comparison with the property-catastrophe reinsurance market. It’ll be interesting to see how these vehicles will develop in size and perform when market conditions improve.”

You can read the full EIOPA report here.