Diversification still attracts investors to reinsurance & ILS: Towers Watson

by Artemis on May 28, 2015

Despite rates in the global reinsurance market falling over the last couple of years, investors continue to show increased interest in reinsurance and insurance-linked securities (ILS) as a diversifying asset class, according to Towers Watson.

In a recent publication, titled “Reinsurance – Down, but not out,” Towers Watson discusses the diversification benefits reinsurance and ILS as an asset class can bring to a portfolio, while noting some industry caution to investors.

“Whilst we are still positive on the asset class from a diversity perspective, the balance of risk and reward going forwards has shifted as a result. We believe the reasons are partly structural and partly cyclical,” said Towers Watson.

The report signals a warning similar to that of certain market investors, participants and analysts of recent months, that “investors review their strategic allocation to this asset class, particularly in light of a broader set of diversifying (alternative) assets.”

As ample competition and an abundance of alternative capital persists in the global reinsurance sector, it’s understandable that market players might want to pull back on their allocation to the asset class a bit, as returns are perhaps no longer at levels they desire.

However, it is wise to remain invested in the space in some capacity, as at some point rates will begin to turn, and when they do it’s best to already be working in the space and have commenced building solid relationships with asset managers, brokers and cedents, instead of then trying to play catch up.

And according to Towers Watson investment in the space is still strong, “largely due to its attractive diversification properties. Insurers now have access to a new source of capital,” explains the report.

Although Towers Watson doesn’t put a figure on the amount of new, alternative capital in the space, it believes “it to be significant relative to the overall capital base.”

In fact, reinsurer Aon Benfield reported not so long ago that the amount of alternative capital in the reinsurance space had reached $64 billion, leading the firm to predict that a total of $150 billion of alternative capital would occupy the sector by 2018.

While an influx of third-party capital does offer opportunities for access to diversified geographical and peril exposures, the report does highlight a possible issue.

While rate declines have taken place across the reinsurance sector, it’s happened to a greater extent for “more liquid instruments, peak perils and transactions covering less remote losses,” explains Towers Watson.

Continuing to explain that typically, the new capital entering the space has been invested in “more liquid and transparent instruments,” such as catastrophe bonds and industry loss warrants, ensuring sub-asset classes of this nature have experienced steeper rate declines.

The study notes that despite rate declines Towers Watson has seen reasonable returns throughout the last few years, and that looking forward the company feels the reasons for lower returns will be structural in nature.

Signifying “A permanent shift in the composition of capital from reinsurance companies to portfolio investors. Because investors have a lower cost of capital than traditional reinsurers, they are prepared to accept lower returns on capital/premiums,” states the report.

Towers Watson adds that opportunities for investors to upsize on allocations to reinsurance and ILS could follow a significant catastrophe event which might diminish some of the capital base in the sector, ensuring a shift towards higher rates.

With structural and cyclical forces continuing to reshape the global reinsurance market, resulting in lower overall returns for many classes of risk, Towers Watson are wise to advise a cautious approach.

But the opportunities and benefits that reinsurance, ILS and catastrophe bonds offer as an asset class are clear, and it’s apparent that investors continue to utilise, some increasingly so, ILS for its strong portfolio diversification benefits.

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