Technology will channel new lines of risk to the capital markets

by Artemis on June 26, 2017

Further disruption is coming to the insurance and reinsurance industry, with advances in technology set to stimulate a shift to some form of trading and placement of new classes of risk more directly with alternative capital and ILS investors, a shift that could be driven by InsurTech efforts both inside and outside of the ILS sector.

Insurtech image from Insurance.meThere is destined to be an acceleration of the disruption that insurance and reinsurance firms have been facing, as technology developments and InsurTech startups begin to drive more efficient risk transfer for new classes of risk.

The growth of the insurance-linked securities (ILS) market, collateralized reinsurance, and other third-party reinsurance capital backed vehicles, has all been about adding efficiency into the risk transfer process, enabling risk to be taken increasingly directly into investment portfolios and funds where returns can be extracted.

With capital markets and institutional investors showing no sign that their appetite for assuming insurance and reinsurance risks is waning, thoughts have to turn to expansion of this market with the end-goal being an increasing proportion of the re/insurance industry’s risks backed more directly by investor money.

The ILS market’s experience with specialty classes of re/insurance business, tentative expansion into some casualty classes, and shift up the risk-to-capital chain to gain greater proximity to the original source of risk, all demonstrate that change is accelerating and the underwriting abilities of the ILS market make its influence much more widely felt than just in property cat.

Some still believe that alternative capital is destined to remain attached to short-tail, property and catastrophe focused reinsurance or retrocession, and that forays into other classes of business will end in tears.

But the times the are a-changing.

If I had a dollar for every technology startup that has identified ILS and the capital markets as its potential future source of efficient risk capacity to back an InsurTech play, I’d probably have enough for a pretty decent dinner by now.

I’ve encountered probably 20 or more Insurtech start-ups that have a stated ambition to work with the capital markets as their capacity provider, more that recognise the opportunity to enable ILS investors a more streamlined route to access risk related returns.

A growing handful of these recognise that one tangible opportunity is to develop a platform that allows for more direct placement of insurance risks into the capital markets, and if these risks cover a broader range than the ILS market currently enjoys access to, then all the better.

There are start-ups looking at ways to break down risks into investable chunks, deploy artificial intelligence and machine learning to better understand and automatically underwrite risks, create marketplaces to bring counterparties directly together, securitize everything (literally), offer robo-advisors to manage your portfolio of insurance risk based on your risk appetite or return requirements, generate liquidity, simulate ILS fund managers, encode insurance risk onto the blockchain, and many more. The list is long and growing.

A theme underlying many InsurTech start-ups that have identified the ILS business model and capital markets as the most efficient to emulate or embrace, is one of accelerating the transport of risk to capital (as we’ve written before), as ILS and InsurTech converge, and if those are new risks, that ILS markets have struggled to assume before, even better.

This fits well with the mission of many ILS funds and investors today, who are all engaged in initiatives that provide them with a way to enhance margins through more direct access to the ultimate source of risk, just like reinsurers are doing as well.

Some InsurTech start-up founders have surprised me with just how well they’ve read the current state of the reinsurance industry and that they’ve identified the opportunity to add efficiency on top of the risk transfer transaction, by peeling away layers of complexity, smoothing the passage of risk to capital, and bypassing legacy steps in the chain.

On top of this they’ve recognised that if you can do all of that and offer a technology platform that makes it possible for the capital markets to access new classes of risk, you could be onto a winner.

Speaking at a recent conference in New York, Dinos Iordanou the CEO of Bermudian re/insurer Arch Capital Group explained to the audience that certain lines of insurance business, beginning with the most commoditisable such as auto lines, or commercial coverages, and finally the excess lines surrounding certain commercial liability lines, all look like they could be targeted for transfer to the capital markets.

Iordanou recognises that as a risk becomes better understood, it can become more commoditisable, at which point the capital markets combined with financial technology and InsurTech could result in these classes of business being channeled directly to investors.

He identified the excess lines as a particular opportunity, as they are relatively well standardised already in many cases, with standardised risks he said it is possible for one underwriter, or piece of technology, to lead, while the capital follows form.

But Iordanou is not saying that this heralds a wholesale takeover of the industry by institutional investors. Clearly as the CEO of a major re/insurer it is in his interests to position Arch at the confluence of risk and capital markets, to ensure that his firm can benefit from the trend towards efficient risk transfer and efficient capacity.

We’d agree, there is still plenty of work for incumbents to do.

Rather, what this means is that reinsurers, insurers and indeed brokers, all need to position themselves to capitalise on these changes, by becoming analysts, pricers and the marshals of risk to capital, be that their own or a third-party source.

Iordanou also hinted at another coming change and the need for markets to be able to put a clearing price on risk.

He said that he believes that in time we will see exchanges or marketplaces emerging for risk to be transferred between parties, resulting in a greater standardisation of layers of risk (where possible) and meaning that transparency increases, and that the frictional costs associated with risk transfer would be reduced.

Iordanou said that exchanges and marketplaces for transacting in or trading insurance and reinsurance risk will create price transparency and add efficiency to the process of transferring a risk, something that will benefit the capital markets and ILS investors as well as aid the traditional market by lowering their costs.

There is a need for re/insurers to have best-in-class technology, such as predictive analytics, in order to garner an edge as risks become more standardised, as this is how they will get paid for their services and be able to offer clients a more frictionless experience.

Iordanou also hinted at the fact that the re/insurance industry has yet to be significantly disrupted by the likes of Google, something that many CEO’s fear in the industry today.

It is one thing to be threatened by start-ups, such as we see with InsurTech today, and most major reinsurance firms are investing in start-ups directly, or partnering with them to provide capacity, in order to ride on the wave of disruption.

But if the world’s largest companies, which just happen to be experts at disrupting legacy industries, start to focus on re/insurance as an opportunity, the ability to be a partner could be lessened and it’s more likely that traditional players would end up being service providers, perhaps at the whim of tech giants like Google et al that owned the customer acquisition and distribution of their products. While the capacity owners could be direct capital market investors.

That’s something re/insurers will be looking to avoid, hence there is so much buzz around the InsurTech wave, as legacy firms look to establish themselves as innovative market leaders.

But there will be a role for Google and others like them, with opportunities to benefit from that for the most nimble incumbents and threats to business longevity for those too slow to see it coming.

As Iordanou suggested, the rate of change in re/insurance is extremely rapid today and as a result risk transfer is changing, the sources of capital are becoming more direct and third-party based, while technology and increasingly sophisticated managers of insurance-linked assets are destined to acquire an increasingly wide range of types of risk.

The fact is that technology makes risks more easily transferable and with less friction, while the capital markets can often be the most efficient and lowest cost destination for those risks.

That means tech players are looking to transfer a much wider range of risks than we see in the ILS market today, into capacity pools that could be largely sourced from the capital markets

If the market does shift to a model whereby advanced technology and marketplaces facilitate an increasing range of risks to be more efficiently transferred to capital providers, the traditional re/insurance market will have no choice but to participate or risk losing out to third-party capital providers.

In fact, traditional re/insurers will have to be the marshalls of this alternative capital to a large degree, or risk finding their own balance-sheet capital less in demand and perhaps also less competitive on both a price and efficiency basis.

If disruption accelerates in insurance and reinsurance markets, as we and many others believe it will, there will still be winners to be found.

But before the winners can be identified, the incumbents are going to have to be ready to adjust business models, adapt to change, leverage technology like a start-up, and be open to working with capital providers that can help to make their capacity more efficient.

Failing to do any of these things could mean a slow and painful passage into the re/insurance history books.

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