Bank of England to review ILS & alternative capital risks in H1 2016

The UK’s Bank of England has been asked to review the potential for risks to arise from insurance-linked securities (ILS), catastrophe bonds and alternative reinsurance capital, as these practices can “create connections between insurance risks and other financial intermediaries.”

According to the latest UK Financial Stability Report (FSR), published and prepared by the Financial Policy Committee (FPC) and released today (December 1st 2015), the FPC has tasked the Bank of England’s staff with reviewing ILS and alternative capital during the first-half of 2016.

The Financial Stability Report, which sets out the FPC’s assessment of the outlook for financial stability in the United Kingdom, discusses the resilience of the UK insurance sector and identifies that while profitability has improved for UK insurers, they are operating in an increasingly challenging environment.

UK insurance and reinsurance “is subject to potential headwinds, which could affect UK insurers’ resilience in the long run,” the FSR report explains.

One factor that reflects this increased competition is the pressure on premiums charged by insurance and reinsurance firms in property catastrophe markets in recent years, according to the FSR report.

This competition is especially strong in the reinsurance market, the FPC note in the report, which is in part due to “an increasing supply of capital from institutional investors, such as pension funds or hedge funds, to support alternative reinsurance activity.”

The FPC note that a substantial proportion of the growth in alternative reinsurance capital is down to catastrophe bonds, which it calculated using Artemis data has increased in terms of cat bond risk capital outstanding from £9.5 billion in 2008 to £16.6 billion in 2015.

The growth of alternative reinsurance capital, while contributing to increasing levels of competition, “could give rise to new risks going forward,” the FPC explains.

The FPC cites catastrophe bonds in the FSR report as an example of risk being distributed outside of the insurance and reinsurance industry and into other parts of the financial system.

In transferring risks outside of the re/insurance sector and into the capital markets and to institutional investors, the FPC says that this can create “connections between insurance risks and other financial intermediaries.”

As a result of the potential for risk being distributed outside of the re/insurance market and the potential for it to create connections between insurance or reinsurance risks and other financial intermediaries, the FPC says it has tasked Bank of England staff with reviewing these risks in the first-half of 2016.

The Bank of England’s Governor Mark Carney, who is also on the Financial Policy Committee (FPC), has warned before about risks potentially associated with the entry of alternative capital into the reinsurance market place.

The latest Financial Stability Report does not deliver a warning, as such, but is the first time the Bank of England has revealed that it is to review the risks that it sees as potentially associated with it.

Of course alternative reinsurance capital and catastrophe bonds (or other ILS structures and tools) are fully-collateralised, meaning that the risk capital backing a transaction or bond is held securely in trust in case it is required for payment of losses.

While risks are transferred from insurance or reinsurance companies (or directly from corporations or sovereign governments in some cat bonds), there is 100% transfer of these risks to the capital providers backing them.

In the majority of cases this is to a sophisticated insurance-linked securities (ILS) investment manager, which has similar expertise to an insurer or reinsurer, in terms of risk modelling, actuarial and underwriting skills.

The risks transferred through ILS or cat bonds using alternative reinsurance capital are not left in the hands of banks, brokers or other financial intermediaries, hence the chance of these “connections” being created to the degree that could warrant any future additional oversight by the Bank of England seems limited.

With the UK working to establish itself as a hub for ILS business, through the work being undertaken by the London Market Group (LMG) and Lloyd’s of London there is bound to be increasing oversight in years to come.

As ever, we’d encourage ILS and reinsurance market participants to engage with the Bank of England and other regulators, when they can, to ensure that those assessing risks believed possible due to ILS and alternative capital are fully informed on the mechanics of the market.