EIOPA cites ILS’ increasing attraction, warns again on discipline

The European Insurance and Occupational Pensions Authority (EIOPA) cites the increasing attraction that insurance-linked securities (ILS) have as a reinsurance and risk transfer tool for sponsors in its latest financial stability report, but warns again that discipline is required.

In the same report though, the European regulator notes that while the sector is becoming ever more attractive for sponsors, the overall profitability of the portfolio of ILS has been reduced, as yields, pricing and ultimately returns to investors have declined. However the EIOPA does make reference to cost-of-capital as a factor in this, which we would suggest shows it has an understanding of the reasons that ILS capital has accepted some of the price reductions.

ILS, such as catastrophe bonds and collateralized reinsurance, are expected to become increasingly attractive as insurance and reinsurance risk transfer tools for sponsors, due to the structures become more comparable to traditional coverage, according to the EIOPA.

The financial stability report, which the EIOPA publishes twice a year, details risks facing the insurance, reinsurance and occupational pensions sector in Europe and discusses market trends. Unsurprisingly the ILS and catastrophe bond market is cited given the continued growth of this space, however the EIOPA notes that while growth in catastrophe bonds and ILS is robust the absolute volumes remain low.

Overall, for the insurance, reinsurance and pensions sector, the EIOPA cites growing macroeconomic risks as continued low interest rates, poor economic outlooks and deteriorating sovereign credit quality all bite. Profitability remains favourable but companies are increasingly under pressure, notes the EIOPA.

Competition is repeatedly cited as a key pressure facing insurers and reinsurers, with capital levels at a high and demand shrinking to a degree. At the same time the ability to profit from the asset portfolio has diminished for insurers and reinsurers, compounding the pressures felt on the underwriting side of the business.

Companies are having to adapt to the low yield environment and the downside risks are growing, warns the EIOPA, this is resulting in new business models in insurance. It’s interesting that this is now being witnessed in insurance at the same time as we are seeing new business models emerging in reinsurance, it’s beginning to look like the macro factors are having as big an impact to re/insurers as the sector specific capital trends.

The EIOPA comments on reinsurance specifically; “The global reinsurance sector continued its robust growth with strong underwriting results and capital returns. The dynamics of the catastrophe bonds’ issuance has been high, albeit the absolute volumes remain modest.”

Given the growth witnessed in catastrophe bonds, ILS and collateralized reinsurance, it’s unsurprising that they are now a regular feature in the EIOPA’s financial stability reports.

A year ago the EIOPA noted that it had a concern that not all investors are capable of modelling and fully analysing the risks they assume in ILS, adding; “Without adequate supervision, such developments could cause systemic risk.”

Then in May 2014, the EIOPA warned of the risk that the excess demand for catastrophe bonds creates a market of risk origination which underprices the risks involved and passes them on to investors who do not have the capabilities to correctly price them.

In the latest report the EIOPA revisits these trends, but also notes that the growth of ILS and alternative reinsurance capital has been most prevalent in a time of flat reinsurance demand and when traditional reinsurers hold record levels of capital. The report notes that the inflow of non-traditional and ILS capital is not all bad for reinsurers saying that some benefit from having access to the capital markets, via structures like sidecars, contingent capital or other forms of risk financing.

However this year the continued inflow of capital markets money into the reinsurance market has clearly been a factor in depressing rates, notes the EIOPA, resulting in some of the lowest cost underwriting capital in a generation.

The real question here is whether the low cost of underwriting capital is below profitability levels for ILS players. It clearly is for some traditional reinsurers, however they do continue to deploy capacity at ever lower costs. ILS is considered to have lower costs associated with it, so the really pertinent question here is where is the breakeven line, in terms of cost of underwriting capital, and has the ILS market got the discipline to remain above it?

The large amount of ILS and alternative capital in the reinsurance market is increasing competition and also reducing the risk spreads for instruments such as cat bond, the EIOPA says. This is having the effect of gradually deteriorating the performance of the ILS portfolio, notes the EIOPA, despite which capital continues to flow into the sector.

Again, this raises the question of where the ILS portfolio becomes unprofitable or so unattractive to investors that it cannot be sustained at such low performance levels. However, if you look at the broader investment universe, the majority of asset classes that the likes of pension funds invest in for diversification purposes return low single digits, making a portfolio of ILS still an attractive prospect for many investors.

The continued entry of capital and the lower cost of coverage in ILS and cat bonds is leading to further price reductions, broadening of coverage through terms and conditions and a trend to cut the cost of public placements, the EIOPA says.

The increased use of instruments like cat bonds also increases the links between reinsurers and the financial markets, warns the EIOPA, which may also result in some opaqueness where it is not entirely clear who holds the risk. The report warns that this makes the reinsurance market more vulnerable to investors’ appetites and procyclical behaviour.

As we’ve written before, these risks do exist in the traditional reinsurance business model, where there is the same risk of a refusal to pay, law suits and the ultimate holder of the risk is actually further removed than in the typical ILS business model. However, the concerns the EIOPA raises are of course valid and only time will tell how the rapidly evolving reinsurance and ILS market manage and control any such risks.

The EIOPA makes a very good point about the technical cost of risk, saying that while capital has the effect of softening prices (which is true for both traditional reinsurance and ILS or cat bonds) the actual risk underwritten has not changed. Here the important factor is that capital is not deployed at levels below the cost of underwriting capital, that while ILS capital may be considered cheaper it does not lower pricing to a degree where it is underwriting below the (currently understood) cost of risk.

While interest rates remain low the effect is that an asset class like reinsurance and catastrophe risk will maintain its popularity, which could produce even more capital markets capacity for the space, the EIOPA says. We would suggest that the ILS space is still being discovered by capital market investors and that when they do, in the current macroeconomic environment, it looks even more attractive. However, investors would still be discovering it even if rates were higher in other asset classes, so while growth could be a little slower it’s generally accepted that the qualities of the asset class would see ILS grow even if the search for yield were not such a factor.

The report notes that ILS capital is beginning to spill outside of non-proportional catastrophe business into other lines of business. Alongside this the investor’s acceptance of indemnity triggers, which has had the effect of narrowing the gap between spreads of indemnity and other triggers, only results in a greater attraction to ILS for new and repeat sponsors, helping to ensure further growth.

“This will raise the attractiveness of ILS further for both new and repeat sponsors, which are expected to issue into the ILS market not only for diversification and complement of overall reinsurance purchases but also due to the alternative market’s competitive pricing and broadening indemnity coverage,” the report states.

So the EIOPA again does a good job of reviewing the ILS sector’s growth and citing the concerns it holds as the use of ILS and alternative capital in reinsurance grows and evolves. None of its concerns are surprising, however it is the ILS market participants responsibility to ensure that everything is done to continue the market’s growth in a stable and disciplined manner.

You can access the full EIOPA report here via its website.