Lloyd’s Nelson warns on ‘systemic’ risk of alternative reinsurance capital

Chairman of the Lloyd’s market, John Nelson, raised the issue of alternative reinsurance capital, the often third-party backed non-traditional capital which has been flooding into the reinsurance market, in a speech yesterday evening and warned against systemic problems this capital could bring to the sector.

Nelson warned, according to a report in the Financial Times, that the influx of capital into the reinsurance market in search of an attractive return with low-correlation to wider financial markets, from institutional investors such as pension funds, could lead to mismanagement of this new capital leading to ‘systemic’ issues of a similar nature to the recent financial crisis.

The in-rush of capital into reinsurance could bring with it the kind of adverse, systemic issues that we saw during the banking crisis, said Nelson, where capital was largely detached from the underlying risk within a transaction. He commented that the insurance and reinsurance industry must avoid those traps.

Nelson’s comments come at a time when the alternative reinsurance market has been growing strongly and exerting increasing pressure on traditional reinsurers, including the Lloyd’s market itself. Lloyd’s has not been immune to the kind of issues Nelson raises, having seen its own scandals of rogue underwriters in its long history, deploying capital with little regard for underlying risk.

Nelson is referring to the often raised issue of underwriting standards in non-traditional reinsurance. Many cite this as a potential issue that requires supervision, with a new breed of small, lean teams, underwriting sometimes billions of dollars of reinsurance business using third-party capital.

Of course, this doesn’t mean that the standards and expertise applied to underwriting are any lower than those at a reinsurer with a few thousand employees. As with every part of the reinsurance market, traditional and non-traditional, there are risks that capital can be deployed without the proper checks and measures.

There have been concerns about the reduction in reinsurance pricing of late, with some highlighting a willingness on behalf of some managers of third-party capital to deploy capacity at any cost in order to build a portfolio and investment track record. In reality cases such as this are few and far between and the majority of ILS managers and collateralized reinsurance structures operating in the non-traditional space are highly experienced and backed by diligent, albeit small, teams including underwriting, modelling and actuarial experts.

Nelson said in his speech that some of the structures being used in the alternative reinsurance market “Undermine the qualities of the insurance model.” However Nelson did also express some positive comments on alternative reinsurance capital, saying that it offers an opportunity as well as a threat, as the additional capital would help the insurance and reinsurance markets fund their own expansion and move into developing regions to meet growing demand for covers.

Nelson stressed that regulators need to keep a watchful eye on how the new capital is used within the re/insurance market, ensuring that capital and risk remain aligned, meaning that transactions are properly modelled, priced and have the appropriate levels of supervision.

Supervision is certainly key when it comes to the deployment of capital in insurance or reinsurance, but both on the traditional and non-traditional side. Non-traditional reinsurers and ILS managers expect, in our experience, to be supervised and to keep underwriting standards high. They can’t afford to let underwriting standards slip as the third-party investors who provide their capital will soon pull it back when the first sign of any detachment between capital and risk become apparent.

More reading:

There are so many reports and commentaries coming out on alternative reinsurance capital and ILS in the run up to the Monte Carlo Rendezvous event that we felt it worth highlighting some other reading on the topic, all from the last week or so, which you can find below (most recent first):

– Demand for alternative reinsurance instruments and ILS to continue: Fitch

– Alternative capital the biggest challenge for traditional reinsurers: Moody’s

– Lloyd’s Nelson warns on ‘systemic’ risk of alternative reinsurance capital

– Broker facilities an opportunity for third-party capital to expand reach?

– Opportunity for reinsurers to learn from ILS: Aon Benfield CEO

– Capital markets investors boost global reinsurer capital to $510 billion (including a useful list of links to many alternative reinsurance capital initiatives that we have covered previously)

– Strong capital inflows bring ILS & cat bond market to new high: Aon Benfield

– Alternative capital a disruptive force in reinsurance: Goldman Sachs