Lloyd’s “structural revolution” forecast, as ILS capital increases share: Analysts


A “structural revolution” is forecast for the Lloyd’s of London insurance and reinsurance market, as increasing quantities of alternative and ILS backed capital become the pre-dominant underwriters of the more standardised and commoditised risks in the marketplace.

Lloyd's of London at nightThe forecast comes from analysts at Macquarie Research, who believe that the innovative steps taken by insurance-linked securities (ILS) funds, as well as the growth of binders, facilities, MGA’s and special purpose syndicates, will all conspire to drive increasing amounts of premium from the more commoditised business underwritten at Lloyd’s to sources of lower cost capital.

We’d agree entirely, and there is certainly evidence to suggest that this forecast is an accurate vision of the future for insurance and reinsurance markets worldwide.

Lloyd’s of London is certainly not immune to the effects of ILS capital and the efficiency of the capital market model. It has done well to fend off a more wholesale entry of alternative capital into the market in recent years, with the barriers to gaining access to Lloyd’s business still remaining some of the highest in reinsurance.

But, while interest from capital continues to increase, there are increasing mechanisms by which it can be deployed into Lloyd’s business. At the same time many traditional Lloyd’s underwriters are no longer able to make sustainable profits on some standardised or commoditised lines of business, suggesting that a lower-cost approach to providing capacity must be found.

This has been becoming increasingly evident across recent renewals, that a tipping point may be emerging which could force the hands of the Corporation of Lloyd’s to become more welcoming to ILS capacity from the capital markets.

If its traditional syndicate players are no longer able to underwrite certain lines of business at a margin, Lloyd’s would either have to face relinquishing a lot of that business to the major global re/insurance players or find a new and more efficient way to get capacity into the market to assist its core underwriting members.

“In a world where insurance is increasingly viewed as an asset class, a range of innovations (e.g. broker facilities, MGA’s, binders, SPS, ILS funds) have opened the market to lower cost capital,” the analysts at Macquarie explain.

This led them to expect that the future of Lloyd’s of London will be one where increasing amounts of standard underwriting business is written at lower margins by ILS and alternative capital, as has already been witnessed with the growth of binder business.

Macquarie forecasts that the Lloyd’s insurance market will itself tier, with two tiers of capital and underwriting expected by 2025.

The first, driven by alternative sources of capacity, will be the standardised business.

“We anticipate that highly commoditised business will be underwritten through broker facilities, MGA’s, binders, Special Purpose Syndicates and ILS funds,” Macquarie’s analysts explain.

The second is the more customised, or specialist underwriting business, where significant experience and sometimes deep knowledge of counterparties is required and this will be driven by traditional equity capital.

“We expect syndicates will limit use of their higher cost equity capital for bespoke products requiring expert underwriters and R&D but commanding a higher margin,” the analysts forecast.

This tiering of capital is already being seen in many global reinsurance firms, particularly the Bermudians, where traditional equity balance-sheets are increasingly focused on the type of underwriting business that can deliver the necessary returns, while third-party capital from investors is utilised for many of the lower-margin catastrophe risks.

It’s a sensible split, as it allows underwriters to get paid for what they are good at, the technical analysis, pricing and structuring of risks, while the equity capital is put to work backing business that meets its cost-of-capital.

Meanwhile more efficient third-party capital, from capital market investors and ILS funds, can still make margin on many softened areas of the market, such as in property catastrophe risks.

Macquaries analysts say that the pressure for change in Lloyd’s is likely increasing this year, as the market’s performance gap from its peers is now negligible, meaning investments in the market for the traditional equity holders are no longer as attractive as they used to be.

Underwriting performance has deteriorated, the analysts say. This is partly due to the dilution of underwriting results, through the continuation of writing this more standardised business. So shifting that business to third-party capital may actually benefit the Lloyd’s market, we’d suggest.

At the same time Lloyd’s costs are particularly high, 40%+ versus peers 30% to 35%, which puts underwriters at Lloyd’s at an immediate disadvantage on an efficiency basis.

Doing business in the Lloyd’s market is not cheap and entry to it no cheaper, which means there are barriers to entry and costs associated with even getting started there, both for traditional and alternative players.

But the barriers for alternative capital have been higher, in recent years, as Lloyd’s has seemingly hindered the growth of ILS capital within its insurance and reinsurance market.

It’s understandable that Lloyd’s wanted to control its entry, to prevent negative impacts on traditional members and syndicates, but now that the re/insurance market has evolved so much, could the control over the entry of ILS capital actually have been a negative for the market or a set back?

Macquarie’s analysts see digital innovation as one positive for Lloyd’s, offering a way for the market to reduce its expenses (they forecast an expense ratio around 35% by 2025). But alone, digital distribution and placing will not add sufficient efficiency alone, not when the more efficient forms of capacity will also be working with whatever digital risk trading and placement platforms they can by that stage.

The analysts believe Lloyd’s is “on the cusp of a structural change” with a shift to this two-tiered approach to risks and capital expected to manifest over the coming years.

“After more than 300 years of Syndicated underwriting supported by equity, we believe that recent innovations in ILS, broker facilities and binders could bring about a structural change in how business is underwritten,” the analysts suggest.

“By 2025, when the current “Vision 2025” plan ends, we believe that the market will have undergone a structural revolution –with two distinct tiers of business emerging; one aimed at homogenous, standardised risks, underwritten with low-cost capital, and the other aimed at bespoke, specialist risks, underwritten with traditional high-cost equity,” they continue.

The resulting market mix would see traditional Lloyd’s syndicates focused on saving their higher-cost equity capital for the specialised risk underwriting where they can get paid for their expertise, areas of the market where competition will be lower and margins naturally higher.

The expense ratio is key to Macquarie’s theory, with traditional Lloyd’s players still expected to have 35% of expenses even after digitalisation in 2025. Meanwhile the lower cost, ILS capital and facility capacity players could have expense ratios as low as 31%, we’d suggest some will be significantly lower, making them the natural home for the more standardised business underwritten at Lloyd’s.

We’d also go one step further and suggest that this standardised business written at Lloyd’s will need to be transferred to low-cost capital providers through digital platforms, as directly as possible, by 2025. Technology trends suggest that the transfer of risk to the lowest-cost form of capital will become the defacto for certain lines of business in years to come, and if securitisation practices are put to work as they should be this will open up the capital markets as the capacity provider of choice for underwriters looking to find a home for these risks.

This “structural revolution” with an increasing share of Lloyd’s business falling to alternative capital and ILS funds is not a particularly radical forecast, but the fact it comes from equity analysts is another sign that the shareholders behind Lloyd’s players are becoming increasingly aware of the influence of the capital markets in insurance and reinsurance.

Lloyd’s of London is, of course, very aware of this influence. However its response has not always been to wholeheartedly embrace the alternative, as it treads a difficult line of trying to protect its members.

Could that come back to bite Lloyd’s in the future? It’s certainly possible.

This structural revolution may never materialise unless Lloyd’s opens up to ILS capital in a more wholesale manner, we’d suggest. Continuing to hold it largely at bay could be detrimental to the market and the company’s underwriting there with margin levels close to breakeven.

2025 may seem a long way off, but it’s not a long time to plan a revolution.

Mechanisms and structures (we mean more than just an Index) to facilitate the entry of alternative capital into Lloyd’s more efficiently would not just benefit ILS players and investors, but also the underwriters who could do with a more efficient source of capacity right now.

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