ILS market transformed into a driver of reinsurance rates in 2013

The insurance-linked securities (ILS) and catastrophe bond market transformed from an alternative source of reinsurance capacity into a driver of rates in 2013, according to the insurance and pension solutions team at Deutsche Bank.

This is an insightful spot by the team at Deutsche Bank. ILS and catastrophe bonds have long been seen as alternatives to traditional reinsurance capacity, providing a way for cedents to diversify their sources of risk capital using collateral provided by capital markets investors.

After 2013, when ILS and cat bonds led property catastrophe reinsurance rates southwards, they can no longer purely be seen as an alternative source of capacity. Rather ILS and catastrophe bonds are one of a number of sources of reinsurance and retrocession capacity and in some cases now the cheapest and most flexible risk transfer capacity available.

With the cost of reinsurance provided by instruments like catastrophe bonds as much as 40% cheaper than it was a year earlier, depending on the level of risk and type of perils involved, ILS is now offered as the best option rather than an alternative to some cedents.

Deutsche Bank notes that reinsurers are continuing to adjust to this ‘new normal’, as premium rates continue to fall on traditional reinsurance lines of business. Some reinsurers are either looking to manage third-party capital themselves to lower their cost of capital, or are sponsoring cat bonds and other structured vehicles to reduce their cost of risk transfer.

This has left ILS and traditional reinsurance in a situation where they are able to compete on pricing and terms, where previously ILS was an alternative that some sponsors were willing to pay a premium to access in return for the capital diversification benefits.

This new level playing field as part of a range of viable reinsurance and risk transfer tools, rather than an alternative to them, has helped to encourage new sponsors into the ILS market. Deutsche Bank notes that 2013 saw a record number of new sponsors, by its reckoning, with seven new sponsors counted by the investment bank (Artemis counts more due to private ILS included in the Deal Directory).

Deutsche Bank said it expects new sponsors and ILS transactions to come to market at a healthy pace in 2014 and believes that 2014 issuance will easily outpace scheduled maturities.

The investment bank expects the cost of reinsurance protection from the capital markets will remain at record lows, with demand from established investors remaining strong and new investors set to enter the space with new funds and reinsurer backed third-party capital management units seeking to deploy capital.

The precedent set by insurer USAA’s latest catastrophe bond, Residential Reinsurance 2013, which saw the riskiest tranche of notes ever issued successfully sold to investors, is set to see attempts to repeat it, said Deutsche Bank. It believes that the ILS market will see layers of risk with greater modelled attachment probabilities issued in future, something that has not been typical before.

Deutsche Bank expects investor demand for riskier tranches of cat bond notes will grow as their search for sources of yield continues. Investing in riskier tranches will also help to offset some the decline in ILS pricing for these investors, helping to boost returns. Of course diversifying your portfolio is set to become even more crucial as higher levels of risk enter ILS portfolios.

Deutsche Bank said; “As the cat bond market develops and converges with the traditional reinsurance market on terms & conditions, it becomes more attractive for sponsors to issue at these riskier layers.”

Deutsche Bank also said that the reduction in the cost of reinsurance may drive sponsors to consider purchasing more and also to purchase reinsurance protection for more remote layers of risk, an area that the cat bond market is well suited to capitalise on.

Any increase in reinsurance buying and demand is not going to be easily secured for ILS investors however, as the competition between ILS and traditional reinsurance is set to continue, said Deutsche Bank, particularly on terms and conditions.