PRA’s 2017 stress test to identify use of ILS and alternative capital

by Artemis on April 12, 2017

The 2017 general insurance stress test from the UK’s Prudential Regulation Authority (PRA) division of the Bank of England is set to identify the use of alternative reinsurance capital, as it seeks information from general insurers on how their capital would respond to severe loss scenarios.

The PRA regularly runs these stress tests, in order to test re/insurer capital adequacy, reserves, and reinsurance arrangements under worst-case scenario situations such as major hurricanes, earthquakes, European windstorms and floods,  a major economic shock scenario.

As we wrote on previous occurrences of these stress tests, the results showed the importance of diversified reinsurance capital to the 26 largest UK general insurers, but are also a good way for the regulator to gain some insight into the use of alternative reinsurance capital and instruments such as insurance-linked securities (ILS).

The reinsurance counterparty landscape is very different today compared to even ten years ago, with the majority of large general insurers counting ILS fund managers and other ILS vehicles among their reinsurance counterparties.

For the just launched 2017 stress tests, which the PRA wrote to insurers about this week, the regulator even mentions the fact that by keeping its hurricane exposure stress test largely the same as the 2015 edition, it hopes to identify “changes over time to firms’ exposures and protections including from alternative markets.”

The results would make for very interesting reading, if they published the full counterparty breakdown and how that had changed over time. From 2015 to 2017 we’d imagine the proportion of UK general insurers reinsurance programs that is sourced from the capital markets has increased significantly.

It would also be interesting to consider what it means for the overall reinsurance market, in terms of the knock-on impact to reinsurance capacity availability after such catastrophic scenarios occur.

With more alternative capital and ILS participation it would seem likely that reloading catastrophe reinsurance programs may become simpler, after the very extreme scenarios occur.

This is because many of the larger ILS fund managers have arrangements in place with investors to reload their investments after major events strike. Where as traditional reinsurers may find reloading their own equity backed capacity takes a much longer time.

On the other hand, there are also questions about how much a complex, but particularly severe catastrophe event may lock-up collateralized capacity and what the impact and overhead for ILS managers may be as a result. Whether this would affect their ability to reload capacity, impacting availability of cover is uncertain. Again, it seems likely the larger players that have arrangements for post-loss scenarios in place would find liquidity, but some smaller collateralized players could struggle.

On the traditional side, such stress tests can help to show up the reinsurance firms who have considerably increased their risk appetites in order to fight off competition from lower-cost ILS capacity, which could see certain players taking an outsized share of the losses.

We’re not sure what level of detail the stress test goes into, as far as revealing the post-event market dynamic goes, but it would be interesting to at least have visibility of where the impact of these stress tests is felt the most and how that impacts both traditional and alternative markets.

The PRA’s stress test is set to identify the participation of some ILS markets and use of alternative reinsurance capital, which alongside findings on how traditional reinsurance capital reacts to these stress catastrophe events, will help the PRA to analyse the resilience of the market to extreme events.

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