Room to grow as ILS & alternative capital demonstrate staying power

by Artemis on June 12, 2014

The staying power of insurance-linked securities (ILS) and alternative reinsurance capital still needs to be demonstrated to some of the world’s largest insurers, for whom reinsurance counterparty risk remains a key coverage buying concern.

For the recent trajectory of growth and success of the ILS and alternative reinsurance capital market to continue unabated there is a need for the capital market providers of risk capital to demonstrate that they will be back to provide new reinsurance cover to clients, even in the event of major losses.

Of course, those in the ILS space know that there is already a body of evidence that institutional investors are prepared to take losses from catastrophe events that their investments are exposed to and also that they are prepared to return to reload reinsurance programs for insurer cedents.

The 2011 catastrophe year saw some ILS managers and investors facing losses and these are ILS managers who remain in the reinsurance market today with even larger amounts of third-party capital to deploy. 2012 saw some ILS players facing small losses due to collateralized reinsurance program exposure to events such as hurricane Sandy, but again these ILS specialists remain in the market today.

Last year’s German and central European catastrophe losses, from flooding and severe hail storms, also took a toll on some exposed ILS specialists, through private or collateralized ILS and reinsurance participation in large European catastrophe reinsurance programs. But again, despite facing some loss of capital, these ILS specialists remain in the market today.

Further evidence can be found in the collateralized retrocession market, where specialist providers of this cover have faced losses, but due to their well diversified portfolios their investors have stuck with them and these specialists have increased their overall third-party capital assets.

So surely there is sufficient evidence of the staying power of this new reinsurance capital? Perhaps, but for large traditional primary insurer buyers of reinsurance there still remains some nervousness about ILS and alternative capitals stickiness.

Australian primary insurance group IAG is a case in point. Despite this insurer buying one of the largest reinsurance programs in the world, it remains of the opinion that ILS and alternative reinsurance capital comes with an additional risk that it may not be there to support the insurer following a major loss.

IAG’s Chief Financial Officer, Nick Hawkins, spoke at a recent Australian Actuaries Institute catastrophe risk event to discuss IAG’s reinsurance capital and how it thinks approaches the reinsurance buying process.

IAG is spending about $700m or $800m Australian dollars on purchasing over $5.5 billion of reinsurance protection this year, explained Hancock. The insurer places a major focus on counterparty risk in its buying strategy, looking to trade with reinsurance partners who it believes are going to be around for multiple years and who will be able to pay their claims when IAG needs the capital most.

For a large insurer like IAG reinsurance capital is particularly important, making up approximately 41% of its total capital, with the remainder being its permanent equity capital and any debt it has in play. As a result the reinsurance purchase is seen as vital to the firms survival and hence the intense focus on counterparties and their claims paying ability.

Hawkins said that IAG’s reinsurance program is in the top five in the world, with between 40 and 50 companies participating in it. Name any of the top 20 reinsurers and you will find them in the IAG reinsurance program, explained Hawkins, but they do not have any one large partner that they rely on, so that they are not too tied to any one source of risk capital. IAG has also embraced multi-year covers in an attempt to remove the requirement to purchase the whole program on an annual basis, which makes the reinsurance buying exercise simpler for the insurer.

Then Hawkins moved on to discuss alternative reinsurance capital. “Even though there’s a lot of new money around in the reinsurance markets and there’s a lot of fresh capital that’s come in, actually we’re still very much a user of traditional reinsurers,” Hawkins said.

With such a large reinsurance program, at over AUD$5.5 billion, that’s no surprise. Hawkins went on to explain why the insurer continues to prefer the traditional reinsurer counterparty.

“We worry about this new money that’s coming in and yes we do trade with it a little bit, but of course we don’t want to have some new best friends in a hedge fund that next year when interest rates go up decide they want to be a bond trader and not a reinsurer anymore and actually there goes that supply,” Hawkins said.

This is where ILS managers, ILS investors and other alternative or third-party providers of reinsurance capital clearly continue to have work to do, as well as significant opportunity for growth, in order to make greater in-roads into these large reinsurance programs. However, it is only by starting off with a small participation in the program, which Hawkins said that new capital already does have, that these longer-term relationships can be built.

By being there and being responsive for IAG when it calls on its reinsurers for assistance to help it to pay its claims and still being there the following year, when IAG wants to replenish or top up its reinsurance cover, the ILS market will prove its staying power and gradually be offered a larger proportion of the reinsurance program.

Of course this could take time, perhaps a number of years and goes some way to explain the relatively slow growth of the alternative reinsurance capital market over the last fifteen years. Insurers with the size, scale and reinsurance needs of an IAG require the security of knowing they can trust their reinsurance counterparties to come back year after year to support their risk capital needs.

Perhaps the ILS market should actually look on this as an opportunity, to prove its staying power and to gradually eat into the traditional reinsurers business with IAG. There is a good chance that this will happen over time, as long as ILS and third-party reinsurance capital providers are also diversifying their own sources of investor capital, to ensure they have investors which are longer-term, as well as those which are perhaps more opportunistic.

“We’re pretty careful to manage who we actually trade with and look after those long-term relationships and I think that’s an as-important aspect of how this works,” said Hawkins.

The relationships that are being built between some of the world’s largest ILS managers and their insurer clients will one day hold the same level of weight with the insurer as its long-term relationships with reinsurers. The ILS and alternative capital players are starting with a disadvantage of being newer to the game, perhaps easier to pick on as potentially less-sticky capital and sometimes are seen as a second tier of risk capital by larger reinsurance buyers.

Those perceptions will change over time, as the ILS market faces losses, deals with them and remains in the game to replenish insurers reinsurance needs. These large insurers, like IAG, will over time develop a greater understanding, appreciation of, and affinity with ILS and the providers of alternative capital and one day the ‘stickiness’ question may go away (to a degree), further levelling the playing field with the traditional reinsurance market.

As that happens another barrier to uptake of ILS and alternative capital will gradually be removed. As the playing field becomes increasingly level, between traditional and alternative reinsurance capital, the benefits of fully-collateralized limit, lower-cost more efficient capital and the innovation of the ILS structure will really come to the fore in the reinsurance buying process (as they already have for some buyers).

The ILS market has faced some losses, but it has not yet faced a real threat from a major U.S. hurricane impact. That will be the time for the market to prove its appetite for risk and for becoming long-term providers of reinsurance with strong and lasting relationships to match its traditional reinsurer competitors.

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