Access to insurance-linked securities (ILS) capacity (the capital markets) is a requirement for insurance and reinsurance firms to remain competitive, with the range of strategies for how to bring more efficient capital within an underwriting business expanding fast.
Taking a step back, access to the capital markets has really been an essential feature of all successful insurance and reinsurance firms since the market began.
The ability to tap into sources of institutional quality investor capital has been a hallmark of success for many of the sectors largest players, since as long ago as the early days of Lloyd’s of London.
Even back in the 1700’s, Lloyd’s underwriters relied upon their wealthy backers, often individuals who could be considered some of the institutional investors of their day.
Throughout the development of the global market for underwriting insurance and reinsurance risk we see today, access to capital has been key for those looking to grow and scale a business. With the capital markets becoming the main source of growth capital, capacity and also importantly liquidity for re/insurers through the last century.
Access to the capital markets has remained key right through the history of re/insurance.
Re/insurers looked to call on fresh capital from investors and institutions after major disasters struck the market. While other entrepreneurs sought to raise capital to launch new start-up companies, to provide the capacity the market required when they noticed an opportunity, a dislocation, or after a capital draining major loss event.
That’s how the capital market’s participated in insurance and reinsurance historically. As funders, backers and start-up capital providers, allowing underwriters to put their money to work in return for enterprise-linked, equity-like returns.
All that changed with the advent of the insurance-linked securities (ILS) market, as it was soon realised that financial technology and its toolkit that includes securitisation could support bringing the risk-linked return directly to sophisticated investors, absent all of the enterprise related risks and uncertainties.
Originally insurance-linked securities (ILS) were designed to provide the insurance and reinsurance market with direct access to the deepest and most liquid source of capital around. To cover the true peak exposures, the major global catastrophe type events that could wipe the re/insurance market, out unless there was someone holding the tail, so to speak.
Along came catastrophe bonds, collateralised reinsurance sidecars, as well as other niche instruments that allowed catastrophe (and in future other) risks to be transferred directly to capital market investors. Investors who would bear that risk in return for their share of the risk premiums.
So, the ILS market developed steadily, as a source of almost backstop capital to begin with. But quickly becoming complementary capacity, enabling re/insurance companies to better arrange, manage and segment their own underwriting portfolios, as leaving some of the risk for others to bear had beneficial capital efficiency effects for traditional insurance and reinsurance balance-sheets.
In tandem with the development of ILS and the capital markets move towards becoming a complementary source of reinsurance, retrocession and now additive underwriting capital, the ILS fund managers of the world steadily built their businesses.
This was focused on solely using the capital markets as an underwriting balance-sheet, while maximising the use of financial technology, securitisation and efficient operations in the model of hedge funds, while also looking to innovate in terms of origination and access to risk as well.
Quickly the largest ILS funds moved into collateralised reinsurance, as their primary way to access underwriting risk, layering further efficiency on top of their business model by removing a significant chunk of the effort and additional costs that were a part of the early catastrophe bond market.
As ILS grew in prevalence, insurers and reinsurers reacted in numerous ways. From burying their heads in the sand, hoping the tide of the capital markets would drain away. To leveraging it as a source of reinsurance and retrocession. While the most innovative embraced it wholeheartedly and brought it directly within their business models.
Fast-forward to today and having access to the capital markets through insurance-linked securities (ILS) has become a requirement for players in many areas of the insurance and reinsurance market.
In fact, we’d go so far as to suggest that without access to the capital markets, using ILS related structures and tools, many re/insurers are damaging their own ability to be as competitive and eroding (or depressing) their shareholders returns (potentially now and definitely into the future).
If you’re underwriting catastrophe risks globally then you really should be considering the use of ILS, either as a tool to smooth your risk curves, a secondary balance-sheet, or by getting paid for your underwriting expertise and access to risk by launching a fund or sidecar.
If you’re operating in other areas of risk, then you should be investigating how you can make best use of the appetite of the capital markets to access relatively uncorrelated sources of risk to bring the efficiency of the capital market into your own business model.
If you’re looking to enter the insurance and risk transfer space, perhaps as an insurance technology (insurtech) start-up, then looking to the ILS market as a source of learnings on how to deliver efficiency across your enterprise and through your capital or capacity is highly advised.
Whether the ILS strategy you follow is in seeking to make your own capacity go further, adding extra efficiency to your overall capital base and operations, generating fee income or a share of profits and getting paid for your underwriting expertise, developing investor relationships for future growth plans, or simply offloading the risks you cannot afford to bear yourself, access to ILS and the capital markets can deliver on all of these for a traditional re/insurer.
Increasingly, global regulatory capital requirements see re/insurers looking for greater tail-risk protection, while more sophisticated players are finding ways to segment their underwriting to leverage diverse and most appropriate, sources of capacity in different places within their books.
Then you have the RenaissanceRe model, where third-party capital is perhaps larger than your equity balance-sheet now, with the fee income delivering attractive profits. While this use of investor’s capital allows you to persist in underwriting markets that without access to ILS capacity availability you may have exited by now.
The whole gamut of strategies are appearing and there are more, diverse and hybrid type models, coming down the line as well.
What does this all add up to?
That in the modern and rapidly evolving re/insurance marketplace, no company should be operating with zero access to third-party or ILS capital at all.
Effectively matching risk with the most efficient capital, with the right risk, return and duration appetite, has become an essential skill and a sign of out-performance, in the eyes of many traditional equity investors.
Insurance and reinsurance firms may well be assessed on their prowess in this area of the market in years to come, as it’s only going to become increasingly important.
Analysts at JMP Securities said it well in a recent report, highlighting the importance of third-party capital, “If a reinsurer does not have an alternative/ILS capital operation of reasonable scale, in our view, it should reconsider its place in the market.”
Of course, diving in and throwing open the doors to third-party capital also comes with its risks, for a traditional equity and shareholder backed underwriting shop.
The question of alignment of interests is one that will always rear its head.
We believe we’re currently going through a cycle where by investors are backing traditional re/insurer managed ILS vehicles again. But this could likely cycle back around to investors seeking fiduciary independence from their ILS investment managers in years to come.
This means the money may not be with you forever, which makes the wholehearted embrace of ILS a tough play for re/insurers, especially those that bring its management fully in-house. Investors remain fickle and their allegiances can change.
Your shareholders may get very used to the additional flow of revenue earned from this business, while your counterparties will rely on your capital.
But if investors, fickle as they can be, choose to exit for a more independent, or direct, approach to accessing ILS returns, the business you’ve built could evaporate relatively quickly, leaving reputations tarnished and capacity vastly shrunken (and less efficient).
This is a real risk for some who fail to embrace ILS and third-party capital with investor interests front of mind. We speak to large institutional investors almost every day and practically every one asks about conflicts of interest.
While right now investors are keen to back re/insurers vehicles, they also bemoan the shrinking availability of independent managers in the ILS space, which to us suggests the shifting allegiances could be part of a cyclical trend that may reverse in years to come.
Hence, yes access to ILS capital is essential these days. But no, it doesn’t have to be brought fully in-house, by everyone at least.
It’s all about finding the right model for you, that supports the ambitions and needs of your clients, employees, shareholders and other stakeholders.
Importantly it’s also about having a responsible fiduciary duty to the third-party investors supporting your underwriting and making sure that they are at least on a level playing field with your shareholders, in terms of transparency, information and ultimately respect.
Just don’t leave yourself too exposed to an erosion and undermining of your market reputation, should the capital decide to back-out or find another type of home from where it can access reinsurance linked returns further down the line.
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