Reinsurance market could lose certain perils to ILS: KBW analyst

The reinsurance industry could lose certain catastrophe risk markets to the insurance-linked securities (ILS) sector for good if, as is expected, the ILS sector continues to be able to assume risk at lower required returns due to its inherent efficiencies and lower cost of capital.

The warning comes from Keefe, Bruyette & Woods (KBW) analyst Christopher Hitchings in a research note which discusses the analyst’s thoughts following Nephila Capital co-founder Frank Majors speech to the Lloyd’s of London insurance market (our coverage of that speech here).

KBW’s view on the speech is that Majors encouraged the analysts with his comments that it only raised capital when it was able to deploy it and that Nephila felt that there are areas of the world that are underinsured which the ILS market can tap for growth. KBW also felt reassured that Nephila would not seek to come down the risk curve, into areas perhaps better suited to rated balance sheet, preferring to focus on the peak perils that Major said the ILS market is best suited to take on.

However, Hitchings said that this message strengthens KBW’s view that ILS capital is substantial, here to stay and that, for traditional reinsurers, the days of superior margins on core catastrophe perils such as Gulf Wind of California Quake are now over.

Hitchings, referring to Majors comments in the speech on cost-of-capital and efficiency, said that if ILS required returns are heading lower, then markets such as these core catastrophe peak perils are lost to the reinsurance industry.

This is a poignant comment and possibly quite accurate. With ILS capital able to take on certain risks in certain layers for considerably lower return than traditional reinsurers, these peak risks are perhaps better left to the ILS markets allowing reinsurers to focus on new opportunities.

It may be dangerous for reinsurers to attempt to compete on price terms on some of these peak risks, those who do may find themselves overexposed with rapidly reducing margins, leaving them extremely vulnerable to catastrophe events or other economic shocks.

While this, ILS markets taking over certain peak perils, could result in a long-term equilibrium, said Hitchings, it also risks reinsurers, having lost a profitable segment of their business, trying to expand into new areas which they often achieve by cutting prices.

Any reinsurers taking that approach could find themselves engaged in a fruitless race-to-the-bottom. That’s a scenario nobody in this market wants to see, equilibrium (as we’ve written before here), is a far more preferable outcome of this period of change.