M&A deals like Markel-Nephila show ILS is about more than just hedging

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Recent merger and acquisition (M&A) transactions, including Markel Corporations planned acquisition of ILS specialist Nephila Capital, show that major re/insurers are increasingly keen to put capital markets capacity and ILS techniques to work in underwriting shorter-tailed primary lines of business.

This appetite, among insurers like Markel, appears to be expanding at a time when the secondary and tertiary markets of reinsurance and retrocession are still only just getting to grips with the opportunity to fully leverage third-party capital and insurance-linked securities (ILS) structures.

But major insurance and reinsurance firms are moving quickly towards a paradigm where ILS is used as capacity to expand their footprint in certain markets, or to sustain their underwriting in markets where equity balance-sheets no longer cut it.

This benefits the traditional player and the ILS unit, partner or investors, enabling a symbiotic relationship that can facilitate expansion for all sides.

Other recent major M&A deal examples, such as AIG acquiring Validus and AXA acquiring XL Group have also demonstrated the appetite of global re/insurers to make alternative capital and ILS work harder for them.

Both of those deals see the acquirer inheriting a healthy third-party reinsurance capital and ILS asset management unit as part of the deal, promising to help them better optimise their use of reinsurance but with the resulting access to ILS capacity able to be used as efficient capital to support expansion and even drive growth.

Markel is perhaps the clearest example though, as it is acquiring Nephila Capital which has already honed its ability to move along the risk-to-capital value-chain in insurance, taking catastrophe and weather exposed risks from as close to the policyholder as possible.

Why might this benefit?

Well even major global insurance and reinsurance firms have restrictions in place about how much catastrophe risk they can underwrite and hold in their portfolios.

Capital charges can be particularly high in some of the most profitable, in terms of rate-on-line, peak catastrophe underwriting zones in the world, meaning only so much risk can be assumed and held onto.

Add to this the fact that margins have fallen significantly, meaning ILS and the capital markets perhaps the only form of capital that can have an open-ended appetite for these catastrophe risks, and it’s clear to see why it is attractive to have an ILS management unit with an appetite for moving along the re/insurance industry value-chain.

Nephila Capital brings Markel expertise in this strategy that is unparalleled in the market, having established numerous routes to source catastrophe exposed property risks from the primary market, backing them with its ILS funds and investor capital.

For Markel, this could come in incredibly useful, as the company may be able to expand its own footprint in peak-zones in markets such as the United States, working alongside Nephila so that the ILS manager takes the peak catastrophe risks, while Markel could retain the attrition and risks ILS funds typically do not want to hold onto.

This would be a true symbiotic relationship, of a parent re/insurance company and its independently operating ILS business unit working together to meet both of their goals.

The parent gets to expand its footprint in markets where its own balance-sheet capital and the related charges it might face would not always allow, while the ILS unit gets to soak up the catastrophe exposed risks its investors desire and expand its own portfolio at the same time.

Of course this approach will lower the cost of capital for the parent, Markel, as well, helping to heighten its own competitiveness in underwriting these peak catastrophe zone insurance policies, safe in the knowledge that efficient capital is as good as on tap to soak up the cat risk component.

But the main thing that the Markel and Nephila deal, as well as the AIG and AXA acquisitions, show, is that leveraging ILS and alternative reinsurance capital is not just about laying off risk to investors to reduce your PML’s, or pure hedging and retrocession.

It’s about more than just transferring or hedging risk.

Embracing third-party capital, within the organisational structure of a traditional re/insurer, is about leveraging the efficiencies of the capital markets to scale out your portfolio in areas where your own balance-sheet is not as suitable anymore, given the compression of the re/insurance market cycle and pricing.

Growth and improved market positioning can now be achieved with the support of efficient ILS capital. Increasingly this is becoming a core strategic lever for a number of global re/insurance market players.

This has already been well demonstrated by a handful of Florida players, although often overlooked strategically by the rest of the traditional market players.

Of course, in the case of Markel and Nephila, it will help enormously that Markel also owns State National, Nephila’s regular insurance fronting partner. The closer relationship the pair can now foster could help to drive further expansion into primary sources of risk for the Nephila ILS funds, offering tangible benefits for Markel as well.

The effect of deals like these, that bring more ILS capital further along the value-chain and into primary insurance, will be additional pressure on pricing in shorter-tailed primary lines, particularly property.

As that occurs, it will of course make leveraging efficient capital to maintain your stake in those markets even more attractive to a major insurer, perpetuating the cycle and resulting in more appetite to have your own ILS unit to support your underwriting capital efficiency.

Leading to an expectation that more M&A deals between a traditional player and an ILS specialist could be on the horizon.

View details of recent reinsurance M&A transactions over at our sister site Reinsurance News.

Also read:

Nephila gives Markel strategic benefits & predominant ILS role: Rating agencies.

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