What a difference two years can make. In September 2013 John Nelson, Chairman of the Lloyd’s of London insurance and reinsurance market, had warned that mismanagement of third-party capital in re/insurance could lead to “systemic” issues in the market.
Yesterday, Nelson was quoted in the Financial Times discussing the launch of the newly planned Lloyd’s market loss and performance Index, acknowledging that insurance risk is becoming an asset class and extolling the virtues of this new or alternative reinsurance capital.
In the past Nelson has been cautious on alternative capital, the growth of insurance-linked securities (ILS) and the potential for ILS having a role in the Lloyd’s market. His commentary clearly shows that he and Lloyd’s saw the opportunity to harness ILS and the capital markets, but that they wanted to approach it in a controlled manner, so as not to introduce undue risks to the market.
Also in September 2013, Nelson explained that “new forms of capital can help the commercial insurance market grow from $600bn to $2tn by 2025.” That was just a week after his systemic risk warning, demonstrating that he clearly saw the benefits of a lower cost of capital for re/insurance capacity, if introduced in the right manner.
In January 2014, Nelson stated in an interview that the changing reinsurance market dynamic created by the influx of new capital from non-traditional sources presented a major challenge for the Lloyd’s market, but that he remained optimistic about the future.
Then at the World Economic Forum in Davos that same year in January 2014, Nelson said that Lloyd’s could evolve to harness the new reinsurance market trends for the benefit of its members, saying that Lloyd’s had the “Luxury that as a market we can frame the way in which we attract capital, the way in which we do business, to suit the new dynamics.”
In Lloyd’s results in March 2014 the report suggested that the market was ready to become more accommodating to capital from new sources and new markets. The report explained; “Work is under way to assess the potential impact of both the evolving strategies and actions of brokers and of the influx of additional non-traditional capital entering the market. The strategic plan will outline Lloyd’s response to these issues and identify specific actions.”
Also in March 2014, Nelson discussed the fact that alternative capital and the inflow of capital market money into reinsurance was pressuring the Lloyd’s market and that this looked set to continue. He again noted the need for the market to evolve to meet the challenges it was facing.
He commented at the time; “Lloyd’s, as a market, has the opportunity over the medium and longer term to harness capital, from traditional and new sources, to meet the growing demand for specialist insurance. This will require imagination and innovation in developing the right structures – blending this new capital with the right approach to underwriting discipline, risk modelling and measurement, and appropriate pricing.”
That was the first time Nelson gave a clear message that Lloyd’s was ready to move with the times and embrace the alternative capital and ILS trend, although it again expressed caution to protect what Lloyd’s means as a business.
Then in April 2014 the new Lloyd’s strategic plan revealed the full scope of the change of direction that the market wanted to take, to try to ensure its future by embracing ILS and alternative capital in ways that would sustain its business model.
In the strategic plan Nelson wrote that Lloyd’s would “Work with managing agents, brokers and capital providers to manage the changing distribution and capital environment.”
Reinsurance convergence was listed as one of six key strategic priorities in the plan. The plan explained the importance of embracing this new capital in a few key sentences.
“Lloyd’s response is to be proactive and to embrace this trend. Over the longer term there is an opportunity to harness capital from both traditional and new sources.”
“Support market-led initiatives that encourage a diverse range of capital at Lloyd’s by removing obstacles and adopting facilitative measures, where appropriate.”
“Build relationships that focus on increasing the understanding of potential new capital providers as to how they can participate at, and bring new opportunities to, Lloyd’s.”
Interestingly the plan also expressed the importance of indemnity as key to Lloyd’s market operations, a particularly interesting statement given the launch of the Index yesterday which promises the ability to create index triggers based on Lloyd’s market and line of business losses. However the plan did also explain that Lloyd’s wanted to encourage the use of new products within the market, rather than outside, which could explain the motivation for the launch somewhat.
Then in May 2014, CEO Inga Beale explained that while Lloyd’s wanted to embrace reinsurance convergence and new capital sources, it didn’t intend to open its doors to every capital provider showing interest straight away.
Again, Beale explained that indemnity was at the heart of Lloyd’s, saying; “We set our stall out to be very much providing indemnity-based insurance products. That goes to the heart of what we’re good at, which is our expert underwriting. We believe in that risk-transfer model. But there are ways, I think, to tap into this capital and convert it into something that then is in line with our indemnity products that we’re offering.”
She also explained the importance that new capital brought new business with it; “We’re out there looking to entice new capital in but at the same time we want them to be bringing something to the table. So if it’s just capital wanting to come into Lloyd’s that cannot bring new business streams in, or new talent pools in, we’re not really opening our doors to them.
“We just want to make sure that they’re bringing new business in when they do and I’m not sure the pension funds are at that stage of being able to do that for us yet.”
Fast forward to March 2015 and John Parry, the Lloyd’s Director of Finance, explained that; “The growth of alternative products and capital is well established in the reinsurance industry and we are determined to harness this trend in the years to come.”
Fast forward again to September 2015 and it was revealed that Lloyd’s was actively working on structures to welcome alternative capital into the insurance and reinsurance market.
A statement from Inga Beale explained; “Recognising changes in the broader marketplace, particularly the reinsurance market, we have been considering ways in which the Corporation can develop structures that would be attractive to alternative capital”
Then in November 2015, the UK government began to put in place the legislative and regulatory framework for conducting ILS business in London, harnessing the work of the London Market Group and publishing a draft amendment to the financial service bill that would allow for a “transformer” special purpose insurance vehicle or structure.
One interesting piece of that amendment implied that Lloyd’s could have a role in oversight, of some description, to these transformer vehicles. As we wrote at the time, that perhaps suggests that it may be possible to establish one of these vehicles specifically to access risks from the Lloyd’s market and transform them out to ILS investors.
But just around the same time in November, John Nelson gave an updated warning on ILS and alternative capital, saying to a conference; “While ILS’s, in the right structure, provide useful additional reinsurance capital, industry and regulators must be watchful in terms of the evolution of their structures.”
While a warning, it was a far cry from the systemic label he gave to alternative capital just over two years earlier.
And so that brings us right up to date to December 2015. You can clearly see the journey that Lloyd’s of London has been on, over the last couple of years, as it first came to terms with the threat of ILS and alternative capital and subsequently worked to embrace it and accept it into the market.
Now, with the announcement yesterday that Lloyd’s is to launch its Lloyd’s Index in 2016, providing an index for diversified insurance risks, featuring loss ratios and data on insurance market performance, which can be used in market-loss type products such as ILW’s and the like, the market has made huge progress.
What was a staunch defense of the indemnity protection appears to have weakened considerably, with the Index offering the ability to create loss triggers based on Lloyd’s market or line of business loss ratios and performance. Clearly that creates the opportunity to hedge more effectively and transfer risks using derivative type structures directly to capital market and ILS investors and fund managers.
Perhaps now Lloyd’s has found the “right structure” that Nelson believes can introduce alternative capital into the market in a sustainable, controlled and helpful manner.
And so, talking to the FT in an article on the launch of the Lloyd’s Index, John Nelson explained; “A lot of people want to increase their exposure to insurance. Catastrophe bonds and insurance-linked securities have been growing, driven in part by very low interest rates. People are starting to see insurance as an asset class.”
And it does seem that the indemnity focus on traditional reinsurance has finally been removed from the official Lloyd’s line. Nelson said; “One of the hopes is that it would lower the cost of capital to the industry, and so to the customer, as it would encourage carriers to hedge risks via instruments rather than via reinsurance.”
It’s also telling that Nelson acknowledges the fact that ILS and alternative capital from third-party investors can reduce the cost of capital in the industry. He says “to” the industry, but of course it is forcing change across the entire insurance and reinsurance market and the industry itself to become more efficient.
As cost of capacity and capital become increasingly important to all parties, pushing a raft of initiatives to lower expenses, raise efficiencies, grow scale and reach, take frictional or superfluous costs out of the value-chain by getting closer to the source of risk, reduce spend on reinsurance, extract more premium value from business underwritten and bring efficient capital within the business model.
People have been seeing insurance, reinsurance and essentially risk as an asset class for over a decade, but now this has expanded into a force that even the largest incumbents in traditional quarters cannot ignore.
It seems Lloyd’s is now fully ready to acknowledge the enormous change that has swept through insurance and reinsurance and the fact that this is continuing, perhaps only really just having begun.
The Lloyd’s market is responding in a positive manner, as evidenced by the change in tone over recent years, the launch of the Index and its work with the LMG. It is going to be fascinating to see how this develops, alongside the initiatives to bring more ILS business to London.
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