Darren Redhead, chief executive of Lancashire Capital Management, acknowledges that four years in a row of trapped collateral, on the back of major natural catastrophes in 2017, 2018 and 2019 and, latterly, the uncertainty stemming from COVID-related claims, does pose a challenge.
“Are we too low as a market?” he asked. “Are we reinsuring people down too low, therefore getting trapped too often?”
Speaking to Artemis around the virtual Monte Carlo Rendez-Vous 2020, Redhead wondered whether the ILS market grew too big, too quickly.
“If you look at the growth of the ILS market over the last decade to 15 years, it has been completely inverse to the pricing environment. So for me, one question is did the ILS market grow at the wrong time?”
“I think there were some funds that just grew for the sake of growing,” he continued. “We are custodians of capital for our investors and our job is to get them the best return for the risk that they’re running. Are they aware of the risk they’re running? And that isn’t just non-modelled perils and trapped funds, it is the actual probability of them losing money. Are they getting paid enough for that?”
With retro prices up by at least 20%, according to Redhead, the pricing environment is improving but he still anticipates a challenging renewal at 1 January. “With the amount of trapped funds, there’s going to be more demand than supply in the retro area which is going to cause further price increases.”
“If we don’t have any major loss between now and year-end it still won’t change anything,” he added. “The COVID situation will probably still be uncertain. So until a lot of those losses have been crystallised there will be trapped funds, which will cause a reduction in capacity going forward.”
Despite hardening rates, business is still being placed within certain classes in the market relatively easily, suggesting a real hard market has not yet been reached. However, Redhead anticipates there will be a ‘Class of 2020’ of reinsurance start-ups.
“The question investors are asking in that arena is how long does the hard market last for? What is a true hard market? For me a true hard market is where you can name your price to finish the placement and I’m not sure that yet exists in a lot of markets. Other people would disagree with me and say there are instances of that within the E&S/D&F space.”
The story is different on the retro side and that may ultimately put the squeeze on smaller market participants, he thought. “Within the retro arena there will be a shortfall of capacity. Is that a true hard market?”
For those unable to access retro protection, reinsurance is only one potential solution.
“You can raise more capital, which we at Lancashire Group have done,” he said. “That’s one way of being able to assume more risk. You can buy cat bonds at the top of the tower, which provides solvency relief.”
“Most people buy retro as earnings protection so there will be other solutions and people will look at other ways and buy less reinsurance. But then you’ll look at some people’s business models or capital structures, ie Lloyd’s syndicates, which are almost forced to buy more reinsurance. So the people who are going to have to buy it are going to be in a more difficult situation.”
“The size of some entities may prove problematic going forward,” he added. “I’m not convinced inwards treaty business will go up as much as retrocessional business and therefore margins will be squeezed even more.”
From an investor perspective, other alternative investments are also looking attractive, which is another challenge for ILS markets as it faces its fourth year of sidepocket reserving.
“For a long time we’ve not really competed with any other assets which are non-correlating and producing the higher returns that the retro ILS market can return. The issue now is there are lots of other distressed investments that our investors can invest in, so we’re competing against them,” said Redhead.