Alternative capital can “bypass” the traditional value chain: Aon

For some year’s now we’ve been saying that insurance-linked securities (ILS) capacity and alternative reinsurance capital is destined to get closer to risk, as structures and technologies advance to allow it to break free from the strictures of the traditional market chain.

So, it’s encouraging to hear that insurance and reinsurance broking giant Aon agrees and feels that the efficiencies and increasingly direct approaches we associate with ILS capital today, are only the start of something much more impactful to come.

At its inception, ILS capacity was seen as an alternative source of peak risk capital, with the depth and liquidity of institutional investors able to absorb the truly enormous tail exposures that insurance and reinsurance market’s face.

But, that tended to put ILS right at the end of a very long and inefficient risk-to-capital chain, in a lot of cases.

Which also didn’t make it particularly cheap either.

As tagging a capital markets securitization deal onto the end of an inefficient insurance and reinsurance market value-chain only added cost, rather than offering a truly competitive alternative.

The cost of issuing cat bonds aside, which is still far too high many would suggest and agree, the ILS market became increasingly efficient, as new structures emerged and new business models, from the ILS fund manager, to the fully collateralized reinsurer, as well as partnerships with direct risk originators.

All of which has helped to narrow, or shorten, some of the links in the chain between capital and risk.

However, in the main, ILS still remained towards the latter end of the value-chain, often used as retrocession or a sort of just-in-time reinsurance capital.

But things are destined to get increasingly direct and efficient, broker Aon believes.

Writing in a recent report, Aon’s experts say that, “With further improvements in data and analytics, alternative capital can potentially bypass the traditional value chain to access ‘pure’ insurance risks.”

“Supported by detailed exposure data and facilitated by emerging technologies, this form of capital is cheaper and allows for more efficient transaction mechanisms compared to traditional forms of capital,” they continue.

Consider an ILS manager that accesses direct primary insurance, likely through a partnership with a risk originator. But utilises real-time data on the construction of the portfolio it is covering, as well as rich analytics and techniques like machine learning or artificial intelligence to optimise and hedge the portfolio on a real-time basis.

The efficiency this can bring to the ILS model will be significant.

As a result, Aon says, “It has significant potential in lowering the long term costs of gaining insurance due to its lower cost of capital.”

Most importantly of all though, such advancements are beneficial to society, in “Enabling insurance to cover more risk.”

That’s a future looking view of the potential for ILS that we fully ascribe to.

Combining efficient capital, capital market techniques and advanced technology, will provide greater coverage across insurance and reinsurance, as well as enhanced returns for the institutions backing ILS structures.

Aon notes that in the past data, technical prowess  and capital were the domain of the major global players, on the insurance, reinsurance and broking sides.

But now, with advancements in technology and abundant capital their dominance is threatened.

“Proprietary data and a large capital base are the two most critical factors that have protected incumbents from competition. However, these factors are severely under challenge from the increased availability of digital data and the emergence of alternative capital,” the broker said.

The fact one of the largest broking houses on the planet recognises this fact is particularly telling.

It provides even more weight to another of our long-standing theses that a “service layer” is emerging in the industry, enabling global players like Aon to find new avenues for revenue, to make itself even more invaluable than it can be through its broking offering alone.

That will also be a very good thing for the market, as sometimes it seems there isn’t actually very much value created in the chain currently, but by unbundling some of these services (the great unbundling we’ve been discussing lately) parties will find new revenue offerings while clients will benefit from enhanced service at the same time. That can only create value.

Also read our article from 2016: On accelerating the transport of risk to capital (ILS + Insurtech).