Insurance linked securities see strong demand as alternative investment: PwC

The future looks bright for a long-term and deepening relationship between the capital markets and reinsurance, according to comments from PwC, citing strong demand for insurance-linked securities (ILS) as an alternative asset class investment.

As investor demand for insurance-linked securities and reinsurance-linked investment opportunities grows the long-term trend is towards growth in the volume of third-party capital actively operating in the global reinsurance market, said PwC in comments published to coincide with the SIFMA IRLS 2014 conference in New York this week.

PwC’s analysis of the ILS sector and capital markets investors indicates that third-party capital is active in reinsurance and ILS not because it is starved of yield elsewhere, but as a long-term diversification strategy for the investors seeking direct exposure to reinsurance risk.

Scott Watson-Brown, Alternative Investments Leader at PwC Bermuda, commented; “We are seeing continuing capital markets interest in reinsurance and alternative risk transfer in 2014. Existing investors are putting more money to work and we are aware of a number of new investors progressing through their due diligence programmes to participate in this blossoming asset class.”

The same questions around the ‘stickiness’ or otherwise of third-party capital in reinsurance and ILS continue to be asked, whether the capital will take flight after a major loss event or if it will flow out of ILS as yields begin to look better elsewhere.

Watson-Brown and PwC believe otherwise, as do the majority of people who are close to the actual investors in the ILS space. He explained; “Our analysis points to an investor base that demonstrates a fundamental understanding of the risks to which its capital is exposed; portfolio allocations are made with this understanding, and allocations are being made following months or even years of in-depth due diligence.”

This is certainly the experience Artemis has in conversations with the end-investor community in ILS and reinsurance. These are not naive capital, as some might have you believe, rather these are typically sophisticated investors who spend significant time to gain an appreciation and understanding of the ILS asset class.

Watson-Brown added; “For any new investor interested in insurance-linked securities or other types of investment in reinsurance, it is critical to have a precise understanding of how a bond or similar structure will perform in the instance of a catastrophic loss and just what spectrum of risks you are exposed to.”

PwC notes the growing trend for traditional reinsurers to manage the third-party capital directly, benefitting from the lower cost of capital within their underwriting and fee income from managing institutional money within capital market structures.

Watson-Brown explained PwC’s thinking on this trend; “For some this is an openly defensive move, but for others we have seen a commitment to take advantage of this broader interest from the capital markets, much broader than we have seen in past years. These reinsurers are adapting to the market place developments and the success stories are coming from those who are innovative and those who differentiate themselves through proven reinsurance programmes.”

Arthur Wightman, Insurance Leader at PwC Bermuda, added his thoughts; “The level of transactional activity is at a higher point than we have seen in the last several years and we expect to see the number of new incorporations of reinsurance entities grow in 2014. Consistent with 2001 and 2006 activity, it’s concentrated in Bermuda once again affirming the attractiveness of the domicile as a sophisticated centre of excellence for reinsurance and innovation.”

The question here is what type of reinsurance entities will become established. In recent months it appears that a range of vehicles, entities and company types are starting-up in Bermuda, with many adopting a third-party capital backed strategy and also more focus on the asset side of the business through asset manager backed start-ups as well.

Interestingly, even the more traditional looking reinsurance start-ups now tend to have something ‘alternative’ about them, such as a high-performing asset manager on the investment side or leveraging third-party capital on the underwriting side.

Wightman continued; “We do expect to see the model evolve in property catastrophe reinsurance – perhaps not as dramatically as some might suggest – both within existing participants as well as new businesses being formed. Core to this as always will be long-term resilience and policyholder protection. For the relationship between the capital markets and risk transfer to sustain over the long term these products must continue to perform. In other words, it would be very damaging if an investor was surprised in any way by how an investment performed when an event occurred. Likewise, if policyholders or counter parties were not well protected over the long-term the value proposition would evaporate quickly.”

The model is already changing, as evident from the new start-ups and the growing third-party capital, ILS and collateralized reinsurance space, the question is how far will that change go. As reinsurers and third-party capital managers adopt new technologies, innovation speeds up and efficiency becomes ever more important on both asset and liability sides of the reinsurance business, the future looks set to throw up some innovative and perhaps surprising new structures and entities, Artemis believes.

Wightman concluded; “The future is bright for a long-term relationship between the capital markets and reinsurance, but it will be important to retain an acute focus on the needs of clients who are hedging their exposures to some of the most damaging forces in nature.”