The preferred terminology used at ILS investment manager Nephila Capital to describe the third-party capital that has entered the reinsurance market, as institutional investors appreciation for catastrophe risk as an asset class has grown, is not ‘alternative capital’, rather it is ‘efficient capital’.
Yesterday, Wednesday 9th October, Frank Majors, co-founder and principal of the world’s largest insurance-linked securities and reinsurance-linked investments manager Nephila Capital, delivered a lecture at the Insurance Institute of London. The lecture, held at Lloyd’s of London, was extremely well attended as the London re/insurance market lined up to hear one of the largest providers of alternative capital discuss his perspective on where the sector is heading.
Chairing the lecture, Grahame Millwater, President and CEO, Beach Capital Holdings Ltd., gave a brief history of Nephila Capital, from its early days as an asset management unit of insurance brokerage Willis Group to the $9 billion of assets and $1 billion of annual premium ILS manager it is today.
Turning to the present day, Majors lecture focused on how Nephila Capital perceives third-party capital, where he feels its sweet spot within the reinsurance market is and where he sees this growing segment of the global property catastrophe reinsurance market going.
Majors began by saying that the pace of change, in terms of capital in the reinsurance market, is accelerating, his presentation slides saying that “Powerful forces have been unleashed – future implications are not fully apparent.” Describing the current, rapidly evolving, market conditions, he implied that even Nephila Capital itself feels like it’s riding a rodeo bull of industry trends.
Nephila Capital believe that the current industry trends represents an innovation within the reinsurance and capital markets and that it is here to stay. Majors said; “We at Nephila believe very strongly that what you’re seeing is based on some very strong fundamentals that are just economic truths that are not going to go away.”
Majors discussed Nephila’s investor base of over 100 institutional investors, describing them as big investors who do a lot of due diligence who understand the asset class and opportunity a lot better than many commentators would have you believe. These investors are cutting big cheques and doing a lot of due diligence before making their investment decisions, he said.
Nephila Capital believes very strongly that the third-party capital which is coming into the reinsurance space is durable. Nephila Capital is 25% owned by KKR and 18.75% owned by MAN Group, which Majors said is important to the firm as it signals to clients and brokers that when there is a need for more capital it can get capital, using all of the resources of MAN and KKR. This positions Nephila Capital as a durable source of capital and platform.
Majors went on to discuss Nephila’s view on a number of key issues which it believes to be truths in the marketplace.
Firstly, Nephila believes that alternative capital does enjoy a sustainable price advantage over the traditional reinsurance balance sheet in peak risks. Because alternative capital is uncorrelated and because of the way firms like Nephila deliver returns to investors, the cost of capital is just lower for peak risks. Majors said this is an important concept that is based on fundamentals.
Nephila believe that alternative capital is permanent capital, that when interest rates go up the asset class will remain uncorrelated and that if there is a major insured loss investors will not panic and flee the sector en masse. Nephila Capital is building its business around that assumption, that the capital is largely here to stay and will grow.
Majors agreed that margins in catastrophe risk are falling but Nephila’s view is that there’s a lot of catastrophe risk out there which does not come to market. “If you bring a lower cost of capital into the industry then the price goes down for the product and more people buy the product,” said Majors. He said the challenge for the industry is to grow the market, meaning that with lower cost capital margins may be lower but there will be more dollars of profit available as it moves from a niche market to a volume market in catastrophe risk.
One of the outcomes of this growing market, with increasing amounts of lower cost capital from alternative sources, is that scale and operational ability of the market participants is becoming ever more important. Operational efficiency is an area that the ILS market is going to increasingly have to address as the market grows in the coming years.
Nephila thinks of alternative capital on a value scale, which explains the lower cost of capital from an investors point of view. The institutional investors who participate in ILS and reinsurance as an asset class find a lower return with less correlation more valuable as an investment than a higher returning asset which is more correlated. On that scale, ILS and reinsurance-linked investments have a higher value than many other alternative asset classes.
Majors discussed current catastrophe reinsurance market pricing, saying that; “Frankly we don’t actually know where the floor price is, but it’s not the current market,” which suggests that Nephila see more room for pricing to decline on the peak risks where it deploys its capital assets.
Majors then displayed some very interesting numbers on the correlation of Nephila Capital’s monthly returns versus other key assets from the firms launch in 1998 to the end of June 2013. Versus U.S. stocks, the correlation is 0.00, versus U.S. bonds 0.12, versus hedge funds -0.09 and versus commodities -0.06. This is a key piece of data in selling ILS and reinsurance to investors, the low correlation with other asset classes is a big piece of the motivation for entering the ILS space.
Majors also showed data which showed how Nephila Capital had performed during crisis periods in financial markets. Again, this data is compelling, showing that Nephila Capital outperformed relative to many other asset classes during times of real crisis in the markets and also displaying the consistency with which ILS returns can be delivered.
Majors said that the lack of correlation of ILS and reinsurance is an; “Incredibly powerful and important aspect of this whole story,” and said “I think it’s going to change our industry.”
Majors explained that equity finance is the peak risk for institutional investors. Investors are ‘full’ of this asset class and are looking to true diversifiers, with lower correlation, like reinsurance and ILS. This again helps to explain why the cost of alternative capital can be lower than traditional reinsurer balance sheets.
ILS and alternative capital also has a cost advantage as it is a discrete risk, which is clean and transparent and so the return requirement is lower than an investment in reinsurer equity which comes bundled with other, sometimes correlating, risks. This helps to explain why ILS can price peak risks such as Florida wind more cheaply than the traditional market.
Majors also discussed the stewardship of capital as an increasingly important skill that the market needs to learn. Equity investors realise that their equity investments in reinsurers are somewhat trapped. Majors said that reinsurers have done a good job returning some capital to investors, through initiatives such as share buybacks, but they probably need to do more of this. For some investors the attraction is moving from one of trapped equity capital to more free invested capital in the ILS market.
Majors said that these factors explain the lower cost of alternative capital and that they also mean more abundant capital. With these attributes of an asset class it appeals to a large base of institutional investors, which means scale but also means durability as well. Majors said; “Alternative capital going into the risk in a direct form, in an uncorrelated form and in a clean form, is here to stay.” Those channels to capital are now open, Majors said and he thinks that with the channels open there will always be access to it.
Majors then discussed some of Nephila’s top investors, showing the percentage of their assets under management that they invest in the firm. The numbers are so low that Majors said that its hard to see how investors would freak out or have an emotional reaction to losses. “The risk is just not big enough to hurt them. They may fire Nephila, because they don’t think we do a good job, but this idea that they are going to panic, I think those numbers tell the story, ” Majors said.
He again reiterated that he sees alternative capital as a fundamental shift that is here to stay and that when capital is needed it will flow to the opportunity, and that now there are more channels to the capital available it is not going to stop.
Majors stressed that alternative capital and ILS is not a business model, not something Nephila invented, rather it is something that is available to everybody in the industry should they choose to adopt it. He called it a technological advancement that the industry can adapt and he thinks it should embrace it.
He then turned to the question of whether there is too much capital in the market, saying that Nephila does not believe there is too much. He said that if there is too much capital in any industry then you retire the least efficient. For peak risks alternative capital is the most efficient, so if the industry is waiting for alternative capital to disappear it will be disappointed. Efficiency is here to stay as it does equal lower costs, explained Majors.
Majors does not see this as a battle between traditional and alternative capital, saying that he does not understand that position as what is being discussed is purely access to capital. Large reinsurers and Lloyd’s itself can access this capital just as easily as Nephila can, Majors said, explaining; “It’s not about business models, it’s about how you finance your activities.” Buyers just want the best product at the best and most efficient price, so it’s about the products you offer your clients, not who they source capacity from.
Majors explains the market as a spectrum, ranging from pure catastrophe bond fund managers, to collateralized reinsurers, to retrocessional providers and traditional reinsurers, with differences in products offered and where capital is sourced from. As we move forwards Majors said he expects that the lines will blur even further and that the description of firms like Nephila being alternative may go away as the market focuses on accessing capital in the most efficient ways to deliver their products to clients.
Majors then moved on to Nephila Capital’s view of what will come next. He said that Nephila expects the market will grow, with new business available to lower cost capital, with more efficient capital helping to spur significant growth in catastrophe reinsurance. He also said that if the industry does reach a point of surplus capacity it may be the equity capital that is the first to leave, not the alternative capital. He explained that Nephila believes that its investors would accept lower returns without withdrawing capital if rates do come down further as the attractions of the asset class would still persist.
The new and more efficient capital will benefit the traditional reinsurance market as a whole, with those who will win having to adapt and re-think the way they manage their capital and with new opportunities due to expertise and talent.
Finally, Majors urged the market to embrace alternative capital and to operate an open door policy to absorb innovations. As the lines between alternative and traditional reinsurance capital continue to blur, the incumbents will need to be ready to embrace change and turn it into opportunity.
Demonstrating demand, Majors said that Nephila Capital is still being inundated with new investor interest even though its funds are closed to new investors currently. “When a $13 trillion pool of capital discovers a non-correlating asset, it’s going to go to that,” Majors closed before questions.
Finally, one of the questions asked Majors what he would prefer this trend was named rather than alternative capital. Nephila Capital is promoting the term efficient capital, he said.
Capital efficiency, both in terms of how capital is managed and the motivations of that capital, is going to be a topic we increasingly see raised by both firms in the ILS space and those on the traditional side. Frank Majors expects the lines to blur, between alternative and traditional models, efficient and equity sourced capital. Artemis agrees. The blurring of lines and the continued evolution of the reinsurance market and model is going to be fascinating to observe in the coming years as this ‘efficient capital’ really finds its feet and the market and products it offers becomes more efficient itself.