ILS capital could help to make run-off market more efficient: PwC

The insurance and reinsurance run-off, or legacy transactions market has continued its growth path so far in 2016, a trend that is expected to continue. And as buyers look to access new capital providers it’s expected that pension funds and ILS vehicles will play an increasing role in the market, according to PwC.

Around this time last year, PwC highlighted that capital markets and insurance-linked securities (ILS) investors will increasingly look to partner with run-off managers to access the returns of non-life run-off re/insurance portfolios.

Predicting further growth of the sector owing to the implementation of Solvency II in Europe, which came into effect on the 1^st January 2016, and the fact that insurers are placing portfolios into run-off earlier than ever in order to improve capital efficiency.

And now, Alan Augustin, Director in PwC’s Deals business, in a new report on the legacy transactions market, has underlined the increased focus of buyers to access new forms of capital. Capital that the ILS market appears willing and able to provide.

“The ever increasing demands from sellers and the competitive landscape has meant that buyers have stepped up to access new providers of capital such as pension funds and ILS vehicles to provide greater bandwidth and flexibility,” said Augustin.

“Partnering and fronting arrangements
with reinsurers are also expected to become more prevalent. Protected cell structures based in Malta, the Channel Islands and as far afield as Bermuda are also now more common and private equity investment, especially amongst the emerging, hungry, mid-tier players is here to stay, though margins are perhaps less healthy as competition for books intensifies,” continued Augustin.

As insurance and reinsurance firms increasingly look to use run-off transactions in order to remove their legacy risk from the balance-sheet and release capital, improve the risk profile of their business, and ultimately make their capital more efficient, run-off activity has increased and is expected to continue to do so.

The global re/insurance market remains under pressure from a series of headwinds, challenges that are also being felt in the ILS space and resulting in capital markets investors looking for yield outside of the competitive landscape.

As noted by Augustin, ILS and pension funds are of an increased interest to run-off buyers as they look to finance deals, but the benefits of participating in such transactions is also being realized by the wealth of capital markets investors. ILS market players are attracted to run-off business as they can obtain a book of business that is put in one place and that is managed by someone else.

While at the same time enabling buyers to access new, diversifying capital to back legacy insurance and reinsurance business.

The ILS market continues to innovate and the insurance and reinsurance sector recognizes that ILS & the capital markets have the appetite to back run-off risks. So as the run-off market continues to expand it’s expected that ILS capital will play an increasing role in the space, providing value to both the run-off market and capital markets investors.

Artemis spoke with Augustin to get some further insight into the development of the run-off market and the growing use of third-party capital and ILS structures within it.

“ILS and run-off activity has been fairly limited to date however we have seen run- off specialists such as Armour Group adopt an ILS structure in collaboration with Credit Suisse and they have been active in the acquisition market over the past year utilising that capital facility to support run-off transactions.

“Darag have also set up R-Pad, their facility to allow external investment into specific transactions. There continues to be significant interest in the run-off space from alternative capital providers such as private equity and hedge funds whose investment and risk profile may fit these kinds of structure, however the heavier investment has been as keynote investors direct into the consolidators themselves rather than sidecar type vehicles, such as Apollo’s and CBPE’s investments into Catalina and Compre respectively.

“Such a direct approach has also been seen by the pension funds with Ontario Teachers also taking a stake in Catalina and the Canadian Pension Plan Investment Board’s investment in Enstar, which is not surprising given the correlation with the recent acquisitions of business such as UK Employers’ Liability, where the tail can be up to 50 years,” he explained.

We asked Augustin how ILS investors could benefit from the tailored portfolios that are available in the run-off market, as the segregated and packaged nature of these seem eminently suitable for investing in.

Augustin responded; “In the current low yield environment run-off continues to provide an attractive option for investors. While the stellar returns seen in the run-off sector in the 1990’s and 2000’s may be a thing of the past with the market becoming more competitive and sellers more sophisticated in their analysis of their portfolios and the prices that are achievable, the run-off market is still very capable of providing stable returns over an extended period still pushing the double-digit range.

“The market also remains substantial – estimated at $247bn for Continental Europe and expected to be of at least a similar size in the US – so investment in vehicles that allow for these kind of returns will remain attractive to the more passive institutional investor.”

ILS capital could also help to lower the cost, and ultimately raise the efficiency of run-off transactions in insurance and reinsurance, perhaps even helping to increase demand in this market as costs could come down.

Augustin said capital is vital to this market; “The run-off market needs ongoing capacity to develop, so a greater variety and flexibility of funding options to run-off acquirers provided by ILS structures, including a lower cost of capital versus more traditional funding methods, should give sellers further confidence that the any gap in the pricing of transactions can been overcome.

“Use of ILS capital as efficient working capital could also reduce the costs of running-off the businesses themselves. Coupling this flexibility with potential increased access to new worldwide markets through a diverse investor base also widens the breadth of opportunities and solutions that may be found.”

Finally we asked Augustin whether the run-off market could shift to one where the re/insurance expertise is as a service provider, specialising in managing the running down of legacy business, while the capital was predominantly sourced from investors in the capital markets.

“This is a model that has been used historically, but only really works where capital providers have sufficient knowledge to have confidence and trust in a management team to deliver. Great strides have been made to improve the professionalism in the industry and as confidence grows, there is more potential for such a structure to succeed,” he explained.

“We have not yet seen a fully developed run-off platform built by an alternative capital provider and, for this to happen, the combined team would need to demonstrate an ability to source and manage run-off books with great efficiency. With a more passive ILS-type investor base, it could mean that a service provider could more effectively ‘get on with its business’ without direct intervention and distraction from overly protective investors, which could, in turn, lead to greater levels of efficiency and return,” Augustin said.

Commenting on the growth of the run-off space in recent times, Andrew Ward, director in PwC’s Solutions for Discontinued Insurance Business team, said; “Europe’s run-off market has had an exceptionally busy year and the transaction environment continues to thrive. Board level engagement on legacy business is still a challenge for Continental European insurers in particular, but the volume of deals we have seen in the UK and to some extent on the Continent shows that legacy is in the spotlight for many (re)insurers.

“Solvency II has really focused attention on the most effective use of capital and is increasingly generating opportunities for acquirers of run-off. Insurers with legacy business are beginning to make decisions around the capital benefits associated with disposing of discontinued books. We expect to see this trend continue for some time as Solvency II becomes embedded within middle tier and more niche (re)insurers.”

Currently, PwC explains that the overall size of the European non-life run-off market remains flat at just short of €250 billion. But with the increased interest from insurers and reinsurers to participate in larger transactions and also the willingness of ILS capacity to assume more legacy risks, the potential for growth is clear and it will be interesting to see how the market performs in the coming months.

Read all of Artemis’ Monte Carlo Rendez-vous 2016 coverage here.