Lloyd’s: Third-party ILS capital is both a threat and opportunity

The Lloyd’s of London specialist insurance and reinsurance market has announced a 2012 profit of £2.77 billion today, bouncing back from a loss it suffered in 2011 of £516m. The Lloyd’s market managed to profit in 2012 despite incurring net claims of £10 billion, with £2.2 billion of that coming from hurricane Sandy. Now Lloyd’s is setting itself up to profit in the ‘new normal‘ of increased capitalisation in the global reinsurance markets and subdued premium rates.

We sat in on the Lloyd’s annual results conference call this morning and wanted to find out how the market intends to adapt, or otherwise, to leverage the current trend for third party investor capital to flow into ILS, catastrophe bonds and collateralized reinsurance. So we asked the panel, made up of CEO Richard Ward, Director of Finance & Operations Luke Savage and Director of Performance Management Tom Bolt, exactly that.

Lloyd’s sees third-party capital from new types of investors with whom it is currently unfamiliar as both a threat and an opportunity, commented Tom Bolt, Director of Performance Management at Lloyd’s. Lloyd’s has recently seen ILS stalwart Nephila Capital enter the market, now backing a syndicate in the Lloyd’s market. They see this as a very focused type of business plan but one which does bring some benefits to Lloyd’s in terms of potential future diversification of capital sources.

Working with Nephila is new to Lloyd’s, it’s the first concerted effort by an ILS market participant to bring capital into Lloyd’s for underwriting in this way. This brings new capital providers into the market who may not be familiar with Lloyd’s and how it works, or who Lloyd’s may not know particularly well, such as pension funds and foreign investors.

This presents an opportunity, Bolt commented, as it gives Lloyd’s a chance to broaden its understanding and exposure to this sector of the reinsurance market and the investors within it. If there was ever a market changing event or loss this exposure may be useful as Lloyd’s can begin to build relationships with new sources of investor capital which could be leveraged should it need to get new capital into the market post-event.

Luke Savage, Director of Finance & Operations at Lloyd’s, mentioned the fact that much of the ILS and collateralized reinsurance market capacity is deployed in ILWs or index-based products, perhaps missing the indemnity cat bonds growth, and said that as Lloyd’s is a market operating on indemnity contracts perhaps capital flow into Lloyd’s from these third-party sources would be limited or restricted.

Given investors appetite for indemnity contracts in the form of catastrophe bonds we’re not sure how much of a limiting factor this would be if Lloyd’s had the facilities and structures in place to really encourage capital market investors to enter Lloyd’s. Perhaps Lloyd’s could leverage its Special Purpose Syndicate structures, even offering preference shares to enable investors to participate directly in those? Special Purpose Syndicates underwrite insurance or reinsurance on a quota share basis for another syndicates book of business, so are similar to some sidecars or SPI’s.

Lloyd’s do not want to see the ILS market become a mechanism for reinsurance business being 100% risk transferred outside of the Lloyd’s market, commented Savage. He also said that the regulatory steps necessary to really embrace all of the structures the ILS market investors like to deploy capital into was a route it did not want to go down.

Interesting responses to our question. Lloyd’s is built on capital, with much of that being third-party from either corporations or the private ‘Names’ who participate in the market. This capital has a particularly long-term view and perhaps Lloyd’s sees the new ILS market breed of third-party reinsurance capital as not reliable or sticky enough to want to encourage it into the market on mass.

However, Lloyd’s places significant importance on the diversity of its capital sources and has a long-term vision to enable more efficient delivery of ‘Names’ capital into the market when it wants to earn premium income. It wants to find ways to make private capital more attractive to the managing agents who operate in the Lloyd’s market and also intends to focus on contingent capital arrangements as well as ways to enhance or simplify structures and contractual arrangements.

All of those long-term goals seem perfectly aligned with the ambitions of the third-party capital in the ILS and collateralized reinsurance markets. It would seem odd if more of the type of capital we write about, and many of our readers deploy, did not naturally find its way into the Lloyd’s market over time. It seems to us that if Lloyd’s wanted to leverage more third-party capital it would not find it a difficult task to encourage investor interest.

The panelists also commented on the Aon – Berkshire Hathaway sidecar type deal, which will see Warren Buffett’s reinsurer take as much as a 7.5% share of all of Aon’s subscription business running through Lloyd’s. Lloyd’s sees it as a complement that Berkshire Hathaway want to participate so strongly in and back the Lloyd’s underwriting market.

The panelists said that Aon intend to use the Berkshire deal to bring incremental business into Lloyd’s, rather than purely seeing business exit the market. That is one challenge that the deal presents as in some cases as much as 7.5% of business could leak from Lloyd’s when Berkshire is on the slip.

Commenting on the statement that an Aon executive made regarding the way that smaller players at Lloyd’s can clog up the market Richard Ward, CEO at Lloyd’s, said that it was a ‘wholly unjustified’ comment and that Lloyd’s does not share that view of its smaller participants. However, inevitably there is always some concern when a large player enters a market which contains many smaller capital sources. The panels comments seemed to suggest that Lloyd’s itself cannot forecast quite how the Berkshire Hathaway deal might impact or change the market over time, or what its impact on the smaller players at Lloyd’s may be.

The influence of an abundance of capital and investor interest in the insurance and reinsurance market, helped by the attractive returns re/insurance offers,will continue to be on Lloyd’s radar it seems but the market does not have a plan or see a need to go out of its way to attract it.

Despite this it seems likely that more deals like the Nephila Capital backed syndicate and the Aon – Berkshire Hathaway arrangement will be looked at seriously by Lloyd’s if they can be thought of as complementary to the Lloyd’s market and its participants. Threat and opportunity, it seems that Lloyd’s will be cautious to ensure that opportunity outweighs the threat as the oldest insurance and reinsurance market in the world adapts to this ‘new normal‘.

For more on this topic see our article from February where Lloyd’s participant Amlin’s CEO said that Lloyd’s must embrace new and alternative forms of capital.