Deloitte on the strategic risk from ILS – “If you can’t beat ‘em, join ‘em”

While the insurance and reinsurance market find’s itself increasingly awash with capacity from all sources, the disruptive effect of the growing insurance-linked securities (ILS) and third-party reinsurance capital is seen as a key risk to re/insurers that should not be ignored.

Interest from capital markets and institutional investors in accessing the low-correlated returns of the reinsurance market has been growing steadily for many years, but accelerated rapidly as understanding and knowledge of ILS and catastrophe bond investments grew in recent years.

As a result, what was at first seen as a deep and liquid pool of capital that would augment global property catastrophe reinsurance capacity has now become a disruptive threat to the traditional insurance and reinsurance business model.

A new report on strategic risk management from professional services firm Deloitte looks at key risks that are emerging and threaten disruption for traditional insurance and reinsurance business models.

Highlighted in the report, alongside emerging risks to the sector and the importance of managing them strategically, is the disruptive threat posed by the ILS business model and alternative capital’s growth in the reinsurance market.

The report looks at risks and how re/insurers should address managing them, through strategic or enterprise risk management, highlighting that for many risks there is a way to turn them into opportunities through effective management.

Deloitte explains; “To more effectively cope with game-changing technologies and new competition from nontraditional sources, insurers should consider adopting strategic risk management (SRM) as a holistic framework to not only help them manage the potential downside of disruptive risks, but also perhaps achieve faster growth by better preparing them to capitalize on the resulting opportunities.”

Deloitte urges that insurers and reinsurers embrace strategic risk management (SRM) practices to gain a competitive edge, saying that “while the disruptive threats carriers face may be transformational,” re/insurers that embrace SRM should enjoy advantages over competitors.

Specifically on ILS, Deloitte’s report explains; “Another notable recent example of strategic risk that is currently challenging the business model of reinsurers is the historic influx of new capital into the property and casualty industry from non-traditional sources, particularly through the sale of insurance-linked securities (ILS) to institutional and individual investors seeking higher returns and uncorrelated risks.”

The professional services firm highlights the effect that the influx of alternative capital and the growth of ILS and reinsurance as an alternative asset class for investors has had on the traditional business.

“The impact has already been disruptive, as the resulting excess capacity has prompted reinsurers to either cut rates to remain competitive, or pull back from affected markets,” the report states.

Deloitte expects the growth of new sources of reinsurance capital will add to the consolidation trend that we currently see in the marketplace.

Deloitte said; “The growth of ILS and other sources—if maintained at its current pace—may trigger greater consolidation in the reinsurance industry.”

However, the important thing to remember, for traditional insurers and reinsurers, is that strategic risks can be managed and turned into strategic opportunities, Deloitte’s report explains.

“This trend could also create growth opportunities for reinsurers as well, at least for those that are flexible and well prepared to capitalize on such disruptions by issuing ILS themselves in the spirit of, “if you can’t beat ‘em, join ‘em.”,” Deloitte said.

Of course the opportunity is not just to issue ILS or catastrophe bonds, to benefit from the lower-cost of efficient ILS and third-party reinsurance or retrocessional capacity, but to manage that capital or bring it within your own business model to really extract the maximum value.

Both insurers and reinsurers are increasingly looking to leverage third-party capital more broadly across their businesses, both for underwriting and for reinsurance or retro purposes. They are also increasingly using third-party capital as a mechanism to help them extract more of the premium value of re/insurance business they underwrite, by retaining it more directly.

At the same time the ILS fund manager specialists and their investors are looking to disrupt the value chain to get their capital closer to the ultimate source of risk.

This trend threatens both greater disruption, but also greater opportunities for those brave enough to embrace ILS and third-party capital. Although caution needs to be taken to ensure that profits are not being cannibalised and that it truly is bringing additional value, rather than just moving that value along the chain.

Deloitte’s advice is sound. It’s vital to engage with third-party capital now, both for insurers and reinsurers, as not only is there a risk of being left behind there is a risk of business models becoming so pressured that managing around the risk posed by ILS will no longer be sufficient.

An industry in flux demands an innovative and open approach to responding to the risks posed. Hence strategic risk management of threats such as alternative capital and ILS is vital.

And if you can’t manage your way around the risks, while maintaining your existing business model, it’s advisable to join them sooner rather than later, as the first to adapt will reap a lot of the benefits.