$200bn loss may not floor London, but could herald huge ILS inflows

A new study that looks at how the London insurance and reinsurance market would cope with an unprecedented $200 billion convergence of catastrophic losses, suggests that while it would not be fatal for London market participants, it could result in a situation where the capital market floods in.

The study results were published today, we covered them over on our sister site earlier this morning, and suggest that London’s insurance and reinsurance players would be able to cope with a two-week period where a severe cyber attack loss, a major Florida hurricane, a significant stock market decline and the failure of a major re/insurance player all occurred.

Coping with such an extreme confluence of loss events would be tough for any insurance or reinsurance player, with massive losses expected across the industry and of course this would hurt the insurance-linked securities (ILS) market and collateralised reinsurance vehicles too.

The scale of the Florida hurricane event, a Category 5 storm hitting Miami and causing an insured loss of between $125 billion and $175 billion, used in the stress test scenario would be sufficient to deal the ILS market a very severe blow.

This event could wipe out a significant number of catastrophe bonds, drain collateralised reinsurance sidecars, trigger many collateralised quota share and excess of loss reinsurance arrangements and also hit the collateralised retrocession market hard.

The cyber loss, which in the scenario caused a major blackout, could also hit some collateralised reinsurance contracts and ILS fund positions covering specialty and energy risks, perhaps even some terror or specific cyber covers.

So the impact to the traditional London insurance and reinsurance market would be very significant, with the report suggesting that recapitalisation would be required for many players, but that most companies would cope with this situation.

Paying claims is not cited as an issue, nor is providing continuity of cover, however recapitalisation seems less assured now that the re/insurance market faces competition from capital market players who would love an opportunity to become more integral to the marketplace.

The report notes that after 9/11 and prior to that other major catastrophic events, Bermuda was a major recipient of new capital flowing into the reinsurance marketplace.

At the same time as facing increasing competition from the likes of Bermuda, London also recognises that many of its market companies are owned by capital from Asia and other regions, and that overall the sources of capital the London re/insurance market leverages are very different to before.

The capital markets and the business model of ILS perhaps provides the greatest threat though, as ILS vehicles could be recapitalised after a major loss event very rapidly. Would London re/insurance market players look to take advantage of this, and would regulators and gatekeepers such as the Lloyd’s Corporation allow and encourage capital to flow back in rapidly through non-traditional structures and means?

Insurance-linked securities (ILS) grew rapidly in the wake of the 2005 hurricane season, with new sidecar vehicles and catastrophe bond sponsors emerging. Since that time of course the ILS market has continued to grow and the appetite of the market to access insurance risk is often discussed as being “pent-up” with significant capital on the sidelines ready to flood into the market at the first opportunity.

Interestingly, of the 17 insurance and reinsurance companies taking part in the scenario, only three suggested they would look to leverage third-party capital vehicles to help them recapitalise after the loss events.

Sidecars, special purpose vehicles or Lloyd’s SPA’s are all cited as possible vehicles for this, however the participants noted the use of third-party vehicles such as this would depend on regulators reactions and their ability to confer with Lloyd’s Names.

Of course, some of the participants would likely elect to recapitalise elsewhere, removing the need for Names to come into the equation and likely choosing a domicile where third-party capital vehicles are more prevalent and can be more swiftly established.

The report notes that alternative reinsurance capital is assumed here to stay and likely to upsize after any major loss event, with fresh capital flowing into the sector. In fact it also notes the position that many take, that inflows from non-traditional ILS sources could be sufficient to radically alter the re/insurance business, flattening out the market pricing cycle.

“If this proved to be the case and existing London Market participants were not able to raise adequate capital during the uncertain times that follow a market-turning event, then it is highly likely that new competitors, backed by non-traditional sources of capital, would emerge in London or elsewhere,” the report suggests.

This is the scenario that could present an opportunity for ILS players with vehicles they can expand rapidly and re-capitalise, as well as for traditional insurance or reinsurance companies that have sidecars or other structures into which they can welcome capital market investors.

The ILS market has sufficient of these structures in place and the largest ILS fund managers have sufficient relationships with very large investors that recapitalisation seems assured. How much the ILS market could upsize its footprint, by opening the capital floodgates is uncertain, but it seems safe to think that the market would be capable of sourcing sufficient reinsurance business to add at least 50% to its size, so perhaps taking it to $120 billion based on the $80 billion it is today.

The traditional market assumes that its recapitalisation routes and strategies are robust and sufficient. But speed could be key here, and if the capital markets could recapitalise more rapidly they could certainly stand to take more market share at that time.

There is also the question of how the recapitalising traditional re/insurers would choose to replace their reinsurance and retrocession, which would have been eroded to a degree. Here the capital markets and ILS funds could stand ready to support the traditional market as it gets back on its feet, providing another opportunity for ILS market growth.

Rates and pricing is another key consideration and some of the participants in the tests said that even after $200 billion of losses price rises would likely be minimal, short-lived and smaller than seen in the past.

Finally, it’s worth considering whether the push-back against the capital markets that has been witnessed in parts of the market such as Lloyd’s in the last decade could perhaps come back to bite it.

Lloyd’s has only recently become more accepting of alternative capital, but still leveraging it is not as simple for a Lloyd’s player as it would be for a company outside of Lloyd’s. Could that hinder the ability of Lloyd’s re/insurers to get back up and running as quickly after such a large loss event, compared to companies outside of Lloyd’s?

That is not discussed in the scenario report, but regulation and the ease with which third-party capital can be raised, deployed and put to work could be key when such large losses strike.

The report does mention that participants stressed the importance that regulators and market overseers are able to respond quickly to changes in models or business plans as required, after such a large event. That would also be necessary for traditional companies who may elect to leverage much more third-party capital after a large loss such as this.

Such enormous insurance industry losses may not kill the industry, and it’s encouraging to read of its resilience to severe catastrophic scenarios and anticipated ability to recover.

But the changes that may be faced after such large losses, as capital inevitably will flow in rapidly from third-party sources further disrupting the traditional model, may result in a different kind of post-event stress test for re/insurers to deal with.