Reinsurance buyers use of insurance-linked securities (ILS), instruments such as catastrophe bonds and other collateralized reinsurance structures, are approaching a saturation point in mature markets such as Florida, according to Validus CEO Ed Noonan.
Noonan said that as ILS remains locked into markets like Florida the chance to grow is constrained and this could mean that use of ILS and capital market backed reinsurance capacity in those markets will soon reach a saturation point.
“Another trend that is interesting to note is that buyers are reaching a saturation point in their use of ILS backed coverage,” Noonan explained during the Validus Group third-quarter earnings call last week.
Noonan was clearly trying to distinguish the differences between the traditional reinsurance product and the ILS or collateralized space, saying; “ILS is predominantly a U.S. phenomenon, especially in Florida and represents about 40% of the capacity purchased in the U.S. market. Buyers are increasingly focused on the lack of reinstatements, the limited life of the product and the fact that there is no guarantee of renewal, all of which are meaningful limitations.”
He went on to offer a few more reasons why buyers appetite for ILS could be drying up; “There’s also too high a rate of litigation on covers that have been triggered in this market.”
That is an interesting comment as we’re only aware of one major litigation involving ILS in more than a year. While there have always been concerns that institutional investors may become litigious after their investments suffer losses, this has not yet been proven to be the case and there’s no reason to believe it will do. In fact litigation seems much more prevalent in the traditional market in recent years.
Noonan continued: “Our sense is that we are at, or near, an equilibrium point for direct insurers using this type of coverage. We expect to see more ILS capital dedicated to the retrocession market next year with associated rate decreases for the product.”
So Noonan feels that the equilibrium will be reached in terms of direct primary insurers leveraging ILS capacity. That may be true of collateralized reinsurance participation in their reinsurance programs, but for instruments such as catastrophe bonds there would seem to be more growth and penetration available in future, especially if some of the large primaries decided to increase their use of these instruments for risk transfer.
The retro market has always been a prime target for ILS, particularly for catastrophe bond, industry loss warranties and other index based retrocessional reinsurance covers. With other indemnity based retrocession options often having capital market backing as well, such as CATCo’s range of products, it is almost certain that the retro market will remain heavily weighted towards ILS and collateralized covers.
When asked by an analyst whether he thinks ILS could increase its penetration of other, less well-tapped, reinsurance markets, Noonan suggested that there is still opportunity for further growth.
“Yes, it could happen. Certainly on a retro basis I think it probably will happen, most retro capacity today is either ILS or hedge fund provided. But as far as the direct insurers and their purchasing, when you get outside the U.S. there’s much more skepticism about ILS,” Noonan responded.
Noonan explained why he feels some markets may be more difficult than others for ILS to penetrate, with buers being more difficult to persuade as to ILS’ strong points; “They feel as though they don’t need it and while they could save a bit, the price gap in places like Europe wasn’t nearly as big between ILS and reinsurance as it was in a place like the U.S.”
This is one of the key issues that has held back ILS issuance and capacity deployment in Europe in particular over the last couple of years. Reinsurance pricing has been so low anyway that the benefits of more efficient capital have been harder to demonstrate. However, we would suggest that this just takes time and ILS has more work to do to increase its penetration of the markets further, something that ILS managers are all aware of and keen to action.
Noonan said that some of the larger European insurers still feel the reinstatements and existing relationship that often come with traditional reinsurance companies are too beneficial to swap for more ILS cover right now. However, ILS is penetrating these markets gradually, operating in a collateralized manner in many large reinsurance programs, in regions such as Europe, Japan and Australia and we can only see that increasing in years to come.
Also it is still early days for ILS and collateralized reinsurance options, particularly in these more traditionally focused markets. It will take time for the coverage options to be accepted and integrated into insurers and reinsurers protections, but as has happened in the U.S., given time this penetration is likely to occur.
Another factor to consider is every insurer and reinsurers wish to move into emerging economies of the world in order to secure a foothold and to capitalise on growing insurance usage. There may come a time when these traditional players find that leveraging the capital markets, either to help them become more expansive, or to free up their balance sheets more in order to grow, is too good an option to miss.
Noonan said; “There hasn’t been anywhere near the interest in places like Europe and Japan around ILS. I think the Australians are probably different and certainly, Florida probably will see more ILS money next year to keep it as ground zero in that sense.”
The feedback Noonan has received from some large insurers clearly shows that there remains work to do in the ILS market to educate on the coverage available for potential cedents. “The general attitude outside the U.S. is just not nearly as favorable to ILS development,” Noonan explained.
This is potentially a huge opportunity for the ILS market and collateralized capacity. The challenge is to demonstrate the staying power of ILS capital, even if some investors come and go, along with the flexibility in options available and the suitability of the product as part of an overall reinsurance or risk transfer program.
If ILS managers, catastrophe bond structurers and collateralized reinsurers can continue to do this, educating the market, innovating to create new products and as a result gradually expanding the capital markets reach in reinsurance, then the coming years should see ILS gradually grow its participation in these harder to reach markets.
If a saturation point is reached in markets that have been the most penetrated by ILS, such as Florida, then the market will redouble its efforts to expand elsewhere. Traditional players would be advised to work with the new capacity, to find ways it can assist them to become more expansive, to create new products and perhaps even to penetrate existing markets more deeply themselves. ILS capacity may be able to help traditional players accelerate entry into China and the growth of its market, for example, so perhaps collaboration will become preferable to competition in the not too distant future.
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