Collateralized product the “catalyst” for convergence growth: A.M. Best

Fully-collateralized structures are, and will continue to be the main catalyst for growth in a convergence market that’s “here to stay” and which plays a vital role in the risk transfer and mitigation process, according to insurance and reinsurance ratings agency A.M. Best.

The insurance-linked securities (ILS), catastrophe bond, collateralized reinsurance, reinsurance sidecar and ILW sectors have witnessed robust growth in recent years, as the increased appetite of institutional investors to access reinsurance exposures for yield and diversification spikes, resulting in the growing acceptance of alternative risk transfer structures and ventures by sponsors and cedants alike.

And according to ratings agency A.M. Best further growth is expected, in a convergence market that “is here to stay and will continue to play an important role in the risk transfer and risk mitigation process for both property/casualty and life/health catastrophe exposures.”

Cost efficiency gains have always be seen as a driver for the increased use of third-party investor backed capital structures like cat bonds and sidecars, a prominent feature of the convergence markets, and this is likely to be a continuous trend moving forward, among other contributing factors, notes A.M. Best.

“The growth of the market will depend on the continued decline in the structuring and transaction costs; the comfort level investors and rating agencies have about modelling of the risks; development of the secondary market for trading of the various ILS instruments and other innovations; and capacity and pricing constraints in the traditional market,” explains the ratings agency.

However, while the growth drivers noted in the firm’s report, “It is Not Your Father’s Reinsurance Market Anymore” – The New Reality,’ ring true, neither are the main force behind the growth of the sector moving forward, according to A.M. Best that is.

“The attraction for cedants to use programs like cat bonds or collateralized reinsurance, which are totally collateralized, versus unsecured promises-to-pay from a rated entity, the hallmark of traditional reinsurance, will continue to be the leading catalyst for growth of the convergence market,” advised A.M. Best.

Underlining the opinion and forecast of A.M. Best is the reality that while growth is evident across all elements of the ILS sector, the two sub-sectors that have witnessed the most impressive growth, as reported by various industry participants and rating agencies, is the catastrophe bond and collateralized reinsurance segments, which are both fully-collateralized alternative risk transfer solutions.

In fact, according to data from the Artemis Deal Directory, (as at September 7^th, 2015) catastrophe bond issuance so far in 2015 has surpassed $6 billion, leaving the outstanding market at just below $25 billion, highlighting a continuation of the strong issuance levels seen throughout 2014, a record-breaking year for cat bonds.

The rapid expansion of cat bond and collateralized reinsurance use during 2014 was emphasised at the close of the year by reinsurer Aon Benfield’s capital markets and ILS division, Aon Benfield Securities (ABS), which noted record volumes of capacity being put to work in both sub-sectors of the convergence market, a trend that has remained in 2015 and that shows no signs of abating.

The ratings agency confirms this view on collateralized reinsurance; “A.M. Best expects to see increased capacity from the collateralized reinsurance sector, with sidecars and ILW sectors providing a small fraction of the capacity as part of the convergence market in the near future.”

Furthermore, A.M. Best predicts a continued rise in the use of cat bonds and cat bond lite structures, while noting that there is a real possibility “for adding other insurance lines, such as the casualty arena, to the property cat business as part of the cat bond fray,” something discussed by analysts at Morgan Stanley earlier this year.

The rise of alternative reinsurance capital and its impact on the traditional reinsurance sector participants is a long-running industry debate, but it’s persistent expansion and increasing cross-over with the traditional business model suggests that it’s here for the long haul, a stance now taken by the majority of industry experts and analysts.

What’s more, as the use of fully-collateralized structures continue to gain traction and a growing base of participants realise the capital efficiency gains and benefits of a truly collateralized risk transfer instrument, the use and acceptance will surely grow too.

Add to this that catastrophe modelling capabilities for emerging risks and emerging, underinsured regions of the globe are constantly improving, through innovation and an industry desire to match the capital with the risk, and it’s hard to see why the catastrophe bond, collateralized reinsurance and wider convergence market instruments would fail to continue to gain market share trend.