Complexity contains competition from third-party capital, for now

by Artemis on September 17, 2014

One of the issues that prevent third-party capital, from sources such as pension funds and other institutional investors, from entering and disrupting the reinsurance and insurance market on a more wholesale basis, is the complexity in some lines of business.

The complexity in much of the insurance and reinsurance world, in terms of long-tailed lines of business, less well-modelled or completely unmodelled perils and lines of business that require specific expertise, does contain the threat and competition from alternative capital and insurance-linked securities (ILS), at least for now.

ILS, catastrophe bonds, industry loss warranties (ILW’s), sidecars and other collateralized reinsurance vehicles are predominantly focused on property catastrophe risks, some life reinsurance risks such as mortality and longevity, a few specialty lines such as crop, energy, marine and aviation and not much else.

The expectation among investors, the ILS specialist investment managers, brokers and indeed reinsurers, is that this remit will widen as ILS structures adapt to new lines of business, as ILS fund managers ramp up expertise in new niches, ILS managers set up new and even rated underwriting vehicles and also as technology advancements increasingly commoditise the underwriting and transfer of risk.

For the moment though the threat to traditional reinsurance and insurance incumbent business models remains largely contained, due to the complexity and also cost of entering some areas of the market.

Meyer Shields, analyst at Keefe, Bruyette & Woods, wrote recently that one of the next re/insurance pricing inflection points would be caused by; “Third-party capital finding a way of underwriting other lines of business, which would almost certainly drive pricing down.”

Shields explained that the ILS market is already actively looking at ways to get new capital into a broader swathe of the re/insurance market, writing; “We believe there are ongoing efforts at creating insurance-linked securities for other lines of business (hedge fund-backed reinsurers are one extant example, but we understand that there are efforts to replicate other property catastrophe-focused vehicles on other lines).”

We too hear of efforts to tap new lines of business all the time and there are many initiatives in their early stages. The complexity that exists today, which contains alternative capital to a degree, may not exist tomorrow and almost certainly won’t exist five years down the line, in many market sectors.

Some ILS managers have been hiring talent to help them to move into more specialty type risks, while others have hired talent to help them target emerging insurance markets with better modelling and analytics. Efforts are underway to find the next opportunities to leverage capacity backed by the capital markets to facilitate better and more efficient risk transfer.

For the moment there is definitely evidence of capital being contained. Some ILS or alternative capital has the appetite to enter new markets, to take on new risks, but lacks the access, the necessary models and expertise or simply the confidence that the time is right to do so.

This containment however is not set to last, as efforts ramp up to broaden the ILS market’s remit. Technology is certain to be a driver of ILS’s expansion, or at least its escape from containment in peak property catastrophe risks and with advancements in analytics, big data and models accelerating rapidly it may not be as long as some people think before contained capital can be set free.

It’s worth noting that some ILS players remain focused on property catastrophe risks and see the growth opportunity in providing more coverage for catastrophe exposures, in more regions of the world and at more layers of the reinsurance programme tower. With so much catastrophe risk underinsured, covered by governments or difficult to access, the growth opportunity for ILS in cat risk alone is significant.

However this won’t stop some ILS managers, investors or enterprising industry figures from finding ways to release third-party capital from its containment and allow it to operate across much broader areas of the reinsurance market in years to come.

We must remember that insurance-linked securities (ILS) and reinsurance linked investing through funds, sidecars, collateralized vehicles and catastrophe bonds are still young, compared to the traditional reinsurance market. As this market reaches its twenties we should expect the access new capital has to broaden and become more deeply embedded in insurance and reinsurance.

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