Be watchful as alternative capital market develops: John Nelson, Lloyd’s

Chairman of the Lloyd’s of London insurance and reinsurance market John Nelson gave a speech in Santiago, Chile recently, during which he discussed ILS and alternative capital, cautioning those listening to “be watchful” as it develops and grows.

Lloyd’s is actively seeking to bring more capital into its marketplace from external third-party insurance and reinsurance investors. The world’s oldest insurance and reinsurance market has seen the rapid growth of insurance-linked securities (ILS) and the growing use of alternative capital and wants a share.

Lloyd’s also recognises that by leveraging more of this capital from institutional and ILS investors it can become more competitive, reducing its own cost-of-capital and increasing the returns on business underwritten in the market.

It can perhaps also hope to innovate, with structures that meet the needs of the investors who like to invest directly into ILS and reinsurance risk, something that could help the market to propel itself into the 21st century.

But Nelson warned those listening to his speech, at the Federacion Interamericano de Empresas de Seguros (FIDES) re/insurance conference in Santiago, Chile on 26th October, that alternative capital and dealing with it is an immediate challenge to the industry.

Nelson said that after protectionism, the “second immediate challenge is the additional capital in the industry.”

“Global insurance and reinsurance markets remain heavily over-capitalised,” he continued, saying that the reasons were lower investment returns available in traditional asset classes, as well as excess capital building up due to a lack of major catastrophic events.

“The influx of non-traditional capital we have seen in the property-cat market in recent years,” has exacerbated the over-capacity situation in insurance and reinsurance markets, Nelson explained, leading to high levels of competition and pressure on pricing.

That leaves the global re/insurance market in a situation with “plenty of capacity chasing reduced premium across the board,” Nelson said, leading to M&A pressures, competitive pressures and re/insurers feeling the need to do anything to stay relevant and maintain their businesses.

Nelson said that the continuity of supply of reinsurance capital is one of the fundamentals for the sustainable development and growth of reinsurance of complex risks. You would think tapping into the capital markets can only help with this, ensuring more capital can be mobilised more rapidly than ever before.

But Nelson warned that; “While ILS’s, in the right structure, provide useful additional reinsurance capital, industry and regulators must be watchful in terms of the evolution of their structures.”

He followed this by noting that; “The impact of complex derivative structures within the sub-prime mortgage sector in the United States led to devastating instability that we must avoid causing in the reinsurance market.”

It has to be said that cautioning to remain aware of risks as a new market develops is one thing, but likening it to a systemically risky practice such as the toxic mortgage debacle in the U.S. is quite another. This isn’t the first time a voice from the more traditional side of the market has sought to make this comparison and it likely won’t be the last, sadly.

However, while we don’t agree with likening ILS to mortgage securities, some caution is never a bad thing, even if the examples used aren’t always the best comparisons.

We feel it’s a stretch to compare the $70 billion ILS market, where not all of the product is derivative based and the motives are not to palm investors off with an unsuitable product, with a U.S. subprime mortgage market that was valued at over $1.3 trillion in 2007 and was clearly suffering from bad-actors.

Nelson went on, saying; “One of the fundamental strengths of our market has been the proximity of capital to underlying risk, leading to greater discipline in terms of risk-adjusted pricing – and this has meant continuity of supply even in difficult conditions.”

Here, we’d venture that the goal of the ILS market is to get the capital even closer to the ultimate source of risk, leveraging financial techniques aligned with expert underwriting, in order to match risk to capital as close to the source in the most efficient manner possible. Hence extracting the best risk adjusted returns.

It’s unclear how Nelson feels alternative capital could be detrimental to supply continuity right now. He is perhaps referencing that it is not as well tested as perhaps traditional capital is, largely due to where ILS plays in the tower right now. It’s also important to note that Lloyd’s itself is a third-party capitalised business historically, leveraging similar types of investors as ILS.

Nelson said that the reinsurance industry fared admirably during the financial crisis, coming out of it in good shape which he puts down to the robustness of the business model. It has to be noted here that ILS also fared well during that period, despite the impact of Lehman.

“I urge us all to be watchful as the alternative capital market develops and use the expertise you have to ensure prudent oversight of your exposure,” Nelson warned.

A warning we entirely agree with, it’s vital to ensure ILS and alternative capital is put to work in robust and sustainable ways, giving confidence to cedants and investors that this is a permanent and growing piece of the global insurance and reinsurance sector.

“We have to make sure that pricing discipline is maintained so that we don’t get, as and when the cycle returns, undue volatility in premium rates. That is in no one’s interest,” Nelson continued, again a sentiment we would agree with, although we would note that if the capital markets soften the peaks of the market cycle that is no bad thing, as it brings greater pricing certainty to everyone.

Nelson is not totally negative on alternative capital by any means, going on to say that “alternative capital can play a vital role in the growth of our market.”

Nelson said that Lloyd’s calculates that “the specialist insurance market looks set to treble from around US$600 billion a year currently to over US$2 trillion in 2025.”

That growth expectation means capital and capacity is required, and here Lloyd’s is prepared to work with alternative capital to ensure it can be securely put to work for the good of the insurance and reinsurance market.

Nelson explained that Lloyd’s is looking closely at; “How we can help to facilitate the alternative capital market in the right structures that make sense to the industry. We plan to come forward with specific proposals later this year.”

Nelson went on to discuss the emerging market challenged of underinsurance and the protection gap, an issue where we feel the holistic approach of insurance, reinsurance and alternative capital investors is required to make real headway.

“Nelson stressed the “need to be disciplined in how we channel capital, and plan this in a structured way which adds real value to the customer,” which is entirely the point of ILS and alternative capital according to many market participants, who see it as an evolutionary step in how risk is underwritten and matched with more efficient capital.

Views differ in the insurance and reinsurance market as to the stability and staying power of ILS investors and will continue to do so. We’re likely to continue to hear speeches featuring warnings on ILS capital, while also citing the opportunities of embracing alternative capital in the next breath as a result.

It’s a strange dynamic of the challenging market environment, something seen time and again. The best response that the ILS market can make is to continue underwriting risks with discipline, being good stewards of investor capital and working to make insurance and reinsurance a more efficient and effective business, for the ultimate benefit of the insurance consumer.