Citi Group highlights insurance securitization as a disruptive innovation

by Artemis on May 9, 2014

Last year investment bank Goldman Sachs highlighted alternative capital in reinsurance as a key disruptive theme to watch in business today. This year banking and investments giant Citi Group has highlighted insurance securitization as an important disruptive innovation.

Citi Group’s research division recently published its second report looking at disruptive innovations which it believes are set to create waves in business and technology today. The report contains ten innovations which Citi believe have the potential to disrupt markets and incumbents and insurance securitization, so including catastrophe bonds, is one of them.

Citi’s report explains what is meant by disruptive innovation:

Disruptive innovation is a term that was first coined in 1995 by Harvard Business School Professors Clayton Christensen and Joseph Bower and explains how “a market or sector is transformed by introducing simplicity, convenience, accessibility and affordability where complication and high cost are the status quo.”

But disruption can be so much more than just a better way to listen to music. Disruptive innovation can be found in both products and processes — i.e. how we do something is just as disruptive to the status quo as the new technology that enables us to do it.

The securitization of insurance and reinsurance risk, through the issuance of insurance-linked securities such as catastrophe bonds, is highlighted as one of the ten innovations that Citi feels could disrupt a market today.

Kathleen Boyle, editor of the Citi Group report, writes:

Typically thought of as a sleepy industry, insurance wouldn’t normally be thought of as a place where you would find disruptive innovation. But the latest surge in insurance securitization through the issuance of insurance-linked securities (ILS) has disrupted the market and forced industry players to consider potentially radical changes to their existing strategies.

Given the disruption that ILS, catastrophe bonds and alternative capital have already caused in the reinsurance market, as they upset the status-quo with their lower cost-of-capital and efficient risk transfer, alongside the very competitive renewals of late, the market can hardly be called sleepy anymore.

The section of the report which covers ILS and insurance securitization is written by Citi’s Head of U.S. P&C Insurance Research Todd Bault and U.S. Life Analyst Erik Bass. The pair write that ILS is, despite being around 17 years old, only now really picking up pace and becoming truly disruptive.

“Securitization is indeed the most disruptive long-term force we see at present: it is already cutting prices, changing market shares, birthing new players, and forcing old ones to consider potentially radial changes to their existing strategies,” they write.

Citi Group forecast for ILS market growthCiti’s research for the report, which it’s pleasing to note includes Artemis as a source, brings them to an estimate of 2014 catastrophe bond issuance reaching $8 billion, 2015 issuance $8.5 billion and risk capital outstanding hitting $21.9 billion at the end of this year and $24.9 billion at the end of 2015. All very reasonable figures given the rapid issuance in recent months.

Looking further ahead and including all sources of ILS capital, so cat bonds, other securities, collateralized reinsurance and sidecars etc, Citi says that it believes that the amount of alternative capital in this space could easily reach $60 billion by the end of 2015, again easy to see occurring.

But on the topic of disruption, of course that is when the innovation begins to impact on the status-quo and the incumbents within a market begin to feel the pressure. Citi writes that 2013 was the headline event when ILS pressure began to really impact on the traditional reinsurance market and reinsurers began to feel seriously pressured as a result.

The report notes that ILS has taken longer to develop than had perhaps been expected, at Artemis we can agree with that having launched back in 1999, but Citi believes that the recent momentum in the ILS market looks sustainable.

Perhaps now, the report says, the ILS market now has the most powerful growth incentive of all, a track record and one which might just be better than traditional reinsurance.

Citi looks at data, some of which is taken from recent Lane Financial LLC reports, and concludes that data perhaps suggests that ILS is producing better risk adjusted returns than traditional reinsurance.

Citi researchers constructed a benchmark to compare leveraged reinsurance with unlevered ILS and came to the conclusion that the returns produced by ILS are closer to the benchmark than reinsurance managed.

The report explains:

We constructed a benchmark to put levered (re)insurance on the same basis as unlevered ILS to allow comparisons of returns. Assuming a needed 16% ROE for traditional reinsurance, this equates to around a 7-8% needed return for ILS. Our assumptions are judgmental based upon our knowledge of reinsurance, but it is interesting that they seem to correspond rather closely to what ILS and Lloyd’s actually produced, with ILS a bit better than needed and Lloyd’s a bit worse. But reinsurance was much worse, consistent with the higher loss ratio data.

Citi goes on to explain that cost-of-capital is not perhaps the most accurate way to describe the advantage that ILS can have over reinsurance, preferring to compare the levered versus unlevered nature of the two.

“Unlevered should have a lower cost of capital than levered. But what’s important is that ILS appears to have done a better job of achieving and exceeding its cost of capital, whereas reinsurers have missed badly,” the writers explain.

Citi says that this is the real disruptive potential of ILS. The report continues:

We would not be surprised if the market share of ILS rises much faster than many expect. Given a successful track record, ILS may be regarded as a vehicle for greater transparency, selectivity, and liquidity compared to reinsurance. This is nothing less than a new principal-agent fight, with investors (principals) possessing a new tool, ILS, to make more demands on agent (re)insurers as to how their capital is stewarded.

The report also takes a look at life insurance securitization (or life ILS) and concludes that it is not dead, but it remains in hibernation and Citi sees significant potential demand from investors for this if the market can be kickstarted.

“Much as we saw with P&C, the key is generating enough investor interest to make pricing competitive with reinsurance. If this occurs, it would be positive for primary insurers by reducing costs, but it would likely increase competition for life reinsurers,” Citi researchers wrote.

Citi says that the key question about the future of ILS and its growth is; “How much might behavior in the (re)insurance industry shift towards that of the capital markets?”

Securitization and ILS has the potential to push reinsurers to be more like their capital markets conterparts. Citi says that it believes that the ILS or securitization model, as well as other innovations such as the hedge fund reinsurance strategy, could be increasingly preferred by investors over providing capital to traditional re/insurers.

Citi adds a few interesting scenarios which it says are not definitely going to happen but could in the ILS markets ongoing development growth.

First, insurers may find that using catastrophe bonds lower down nearer to their own retained risks, caused their investors to demand that they utilise them more resulting in a perception that these risks belong in the capital markets.

Citi notes that when the ILS market began this was the original thinking, that ILS and the capital markets could cope where there was insufficient reinsurance capital. This is wrong, Citi says, rather this would be comparable to banks interest rate hedging, so insurers would be expected to hedge their risks and cat bonds could be the most efficient mechanism for this.

Another is the continued rise of the hedge fund backed reinsurer as capital models change and more active investment strategies continue to be in demand. Finally, more questions may be asked about the reinsurance model and whether they should be underwriting on their own balance sheets or acting more as underwriting managers and passing on that risk to the capital markets. A truly fundamental change that we write about regularly as a possible end game for some reinsurers as alternative capital takes greater shares of the market.

The report from Citi is fantastic and well worth a read if you can acquire a copy, not only for the ILS content the other nine disruptive innovations (including 4D printing, digital banking, precision agriculture, immunotherapy and more) are equally fascinating and thought-provoking.

ILS is receiving increasing interest in the mainstream press, is becoming a core component of many reinsurance programs and clearly has much more disruption to bring to insurance and reinsurance as the innovation continues and new products and structures emerge in years to come.

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Emily Gilde July 1, 2014 at 1:15 am

On a long plane ride home yesterday, I read with great interest an essay in the June 23 New Yorker by Jill Lepore entitled, “The Disruption Machine: What the Gospel of Innovation Gets Wrong.” This essay brought to mind the recent Citi report citing the growing ILS market as an example of “disruptive innovation” in explaining how, to quote Clayton Christensen, the Harvard Business School professor who coined the term, “a market or sector is transformed by introducing simplicity, convenience, accessibility and affordability where complication and high cost are the status quo.”

Although this conclusion regarding ILS has much intuitive appeal, Lepore’s essay gives pause for thought. She argues that disruptive innovation as a theory of change is not well grounded in factual evidence; it is a “theory of history founded on profound anxiety about financial collapse, an apocalyptic fear of global devastation and shaky evidence.” Strong words!

A key feature of “disruptive innovation,” as explained by Christensen, is that it overturns the established order through the introduction of alternative products that are cheaper and inferior to those sold by established suppliers. An example from Christensen’s book, “The Innovator’s Dilemma,” cited by Lepore, is computer disk drives. Christensen names 116 innovations in computer disk drives, of which 111 were “sustaining innovations” and 5 were “disruptive.” The 5 disruptive innovations each introduced “smaller disk drives that were slower and had lower capacity than those used in the mainstream market.” According to Lepore, Christensen claims that each company that adopted one of the 5 disruptive innovations drove out an established firm. Lepore disagrees with this interpretation of history and, with considerable care, builds the case that in fact, the “disruptive innovators” ultimately did not succeed, and the existing companies prevailed – changed, but still the market leaders:

“In the longer term, victory in the disk-drive industry appears to have gone to the manufacturers that were good at incremental improvements, whether or not they were the first to market the disruptive new format. Companies that were quick to release a new product but not skilled at tinkering have tended to flame out.”

Lepore cites several other case studies of “disruptive innovations” from Christensen’s book in which he claims that the innovator drove out the incumbent. Lepore claims the facts, as they ultimately played out, are otherwise. She concludes that, in the long run, “many of the successes that have been labelled disruptive innovation look like something else, and many of the failures that are often seen to have resulted from failing to embrace disruptive innovation look like bad management.”

So what does this mean for ILS? Is ILS as a “disruptive innovation” an example of a “lower cost but inferior alternative” to traditional reinsurance? From a cedent’s perspective, I believe in some sense this is true. Although catastrophe bonds have become much more sponsor-friendly in the last few years, they still involve higher legal costs and more company resources than traditional reinsurance. Terms such as mandatory commutation, reduced flexibility with respect to non-modeled risks and perils, and more formal loss reporting requirements are other drawbacks. When my previous employer first entered the cat bond market as a sponsor, we viewed the real benefit of ILS as the opportunity to access a new, complementary source of capital that could help stabilize pricing and capacity in the industry in the long term. We never viewed cat bonds as a perfect substitute for traditional reinsurance partnerships.

If Lepore’s interpretation of history is correct, i.e., that history rewards the “tinkerers,” we should expect that the differences between traditional reinsurance and ILS will continue to blur, that prices will stabilize at lower levels (creating the potential for great social benefit) – but that many of the existing reinsurance players will remain – changed – but still market leaders.

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