Alternative reinsurance capital & ILS to grow, expand remit, stick around

Industry participants at Standard & Poor’s Ratings Services’ 30th Annual Insurance Conference said that they expect alternative reinsurance capital and ILS to keep growing, expand its remit and agreed that the new capital is here to stay, even post-event.

The conference saw participants in a number of panels discuss alternative reinsurance capital and insurance-linked securities (ILS), once again demonstrating that it is a trend in the reinsurance market that people cannot stop talking about.

While some would like to avoid admitting that the emergence of third-party capital and ILS in reinsurance has disrupted the sector, the popularity of the topic and the fact that industry leaders feel the need to constantly comment on it (and justify their own business models) clearly shows the disruptive nature of ILS and the fact it is continuing to pressure traditional reinsurance market players.

Of course with catastrophe bonds having seen record issuance in 2014, with over $9 billion of risk capital issued in the last twelve months, as well as increasing use of collateralized reinsurance and private ILS structures at renewals and a growing total amount of alternative reinsurance capital, it is no surprise that it remains a topic executives want to discuss.

In fact the market in ILS and third-party capital backed reinsurance structures is still not growing fast enough to absorb investor capital, with ILS investment managers continuing to turn down new capital as they cannot deploy it quickly enough.

Greg Hagood, a managing partner at the largest ILS manager Nephila Capital, explained on a panel about ILS that Nephila cannot put capital to work fast enough. “We’ve turned away a significant amount of money in the past 18 months,” commented Hagood, adding that his firm “couldn’t put it to work.”

Other panelists agreed that the inflow of capital is likely to continue, with investors increasingly gaining an appreciation for the insurance and reinsurance linked investment asset class. While reinsurance remains a market-beating source of diversifying returns this attraction is expected to continue to grow.

On one panel Michael McGavick, CEO of XL Group, commented that the growth in ILS and alternative reinsurance capital may be slow but it is happening. “We’re at an early phase of an inflection point,” McGavick commented, adding that interest from investors could also fade if they faced significant losses.

ILS and alternative reinsurance capital is expected to expand its remit, with the broader reinsurance market, branching out into new lines of business and taking an increasing proportion of the traditional reinsurance markets business.

Jay Fishman, CEO of U.S. primary insurer Travelers highlighted casualty risk as an area of interesting development for ILS and new capital providers. “New capital tends to go where the barriers to entry are the lowest. Right now it’s predominantly property oriented, but what will be interesting to watch is people exploring casualty reinsurance,” he commented.

David Lalonde, senior VP in the Consulting and Client Services Group at risk modeller AIR Worldwide, cited cyber risk as a potential area for alternative capital to move into. Lalonde said that a terrorism risk model could be used to help capital providers understand the risks of cyber attacks.

Flood was again cited as another likely peril that the ILS market could assume, however Lalonde warned of the difficulties involved in modelling flood risks but said that as the commercial exposure to flood is so high, it makes a natural risk for the capital markets to try to assume.

Jay Green, senior vice president at GC Securities, echoes Lalonde’s comments, adding that it is a challenge to structure a flood trigger over a large geographic area, but it is the kind of cover that clients want and therefore is likely to continue to be pursued.

Risk modelling technology is expected to drive the ILS markets growth, with advances in data, technology and the amount of historical loss data available to users of models expected to help the ILS and alternative reinsurance capital market expand, panelists agreed.

As ever, a topic covered was the staying power of ILS investors and alternative capital in reinsurance, with panelists giving the usual responses that unexpected losses or particularly large losses may chase some capital away.

Greg Hagood of Nephila Capital said that some investors would likely leave the space after facing losses from a catastrophe event such as a hurricane. However, Hagood explained that it is not a simple answer and that while some investors might leave, others would stay and increase their allocations to ILS and reinsurance while still more new investors might enter the market at that time.

“My inclination is that after one big event, it’s a net positive in terms of inflows and outflows,” commented Hagood, suggesting that inflows of capital would be larger than any outflows that the ILS market might experience after a loss.

Jay Green of GC Securities agreed that investors were more sophisticated that many are prepared to acknowledge, meaning they are likely to stick around after an event. “One earthquake won’t send
them running for the hills,” Green said.

On the topic of unmodelled or more complex risks, the inclusion of meteor and volcanic eruptions in the recent Residential Reinsurance 2014 Ltd. (Series 2014-1) was discussed. Hagood said that he questioned how the market might model for volcanoes and meteors, adding that the combining of correlated and uncorrelated perils could result in a “bifurcation in the market” with complex and simple risks in the same pool, something Hagood said there was nothing wrong with.

Green responded that pricing unmodelled risks into ILS and catastrophe bonds is a natural evolution of the market and that it could actually present an opportunity for investors. “Investors could take advantage of that bifurcation risk,” Green explained.

The general theme from the event was that alternative reinsurance capital and ILS instruments such as catastrophe bonds are here to stay and will keep increasing, but some uncertainty remains about how the market will react to both an expected loss, so one that is in the models, as well as an unexpected one.

The expectation is that ILS investors will find ways to branch out into new lines of business and new classes of risk, with the likely impact further softening of reinsurance prices outside of the peak peril catastrophe zones. How ILS and alternative capital will impact sectors such as casualty is less certain, but panelists at the conference suggested that its impact could be as dramatic as the one we’ve witnessed in property catastrophe.

The disruption to the incumbents in the reinsurance industry does look set to continue, but some of the reinsurance CEO’s speaking at the S&P event said that they expect to be able to avoid some of this disruption by playing a leading role in growing the reinsurance market into new regions of the world.

Here reinsurance CEO’s feel that they can be leaders, opening up new markets and acquiring new sources of risk and premium. Of course once reinsurers have established new markets, the ILS players could just follow on behind, meaning that alternative capital will be able to expand into those new markets as well. This leading role of expanding the market may not be a business model with a long future and in fact these reinsurers may be better served by leveraging third-party capital to aid this expansion, thus securing a longer role in those markets for themselves.

It will be interesting to see how the traditional players cope with being chased around the world by lower-cost, more efficient capital, if that scenario played out. An inability to secure these new markets for themselves permanently could make the effort a costly exercise in creating models, opening new markets, setting rates and then finding themselves disrupted by new capital (again) for reinsurance companies.