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No immunity for ILS funds as reinsurance reshaping continues: Willis


As the relentless pace of rate reductions continues across the global reinsurance market, while macro conditions and the inflows of alternative reinsurance capital reshape the reinsurance landscape, ILS funds can no longer be thought of as immune to these challenges.

There was no respite again at the April renewals for the reinsurance market, as rate declines and broadening of terms continued. In its latest report, reinsurance broker Willis Re highlights an “urgent – and ever increasing – need for change across the reinsurance industry as it forms a new paradigm.”

Willis says that the reinsurance market cycle is now under “extreme strain” and as a result reinsurers are displaying a clear sense of urgency to implement major changes to their strategies and business models.

As reinsurers seek to adapt in order to navigate the markets challenges, it is becoming apparent that change has become so deeply felt that the efficient business model of the insurance-linked securities (ILS) fund managers can no longer be thought of as immune to these pressures.

“The need for change is compounded by the growing transparency of major buyers around their core partner strategies, and their reluctance to deal with smaller following markets,” said Willis.

These are factors that are also affecting the smaller ILS funds, causing them to also evaluate business models, options for increasing scale and diversity and even to consider partnerships and perhaps in the future mergers.

Reduced returns and downward pressure on fees is putting the business models of some smaller standalone ILS managers under strain, Willis says.

Peter Hearn, Global Chairman of Willis Re, commented on this trend; “ILS fund managers evolving into more traditional reinsurer models and reinsurers expanding their own fund management activities appear best placed to trade through this difficult period; they can manage investors and access business more effectively.”

John Cavanagh, Global CEO of Willis Re, concurred saying; “There are no signs that the current tide of falling rates and widening terms and conditions will be reversed. Diversification is now the key competitive advantage in this increasingly consolidated and converged reinsurance industry, and the ability to deliver a differentiated service offering is critical. Everyone should be broadening their horizons.”

Willis highlights the example of AQR Re, which was pulled out of the space by its owners AQR Capital Management just recently. It’s without doubt that smaller dedicated ILS players may be finding things a lot tougher in the current market of reduced returns. However many are also still thriving.

The example set by Stone Ridge, growing to over $3 billion in two years during the period that reinsurance market challenges really set in shows that the efficient capital model still stands and the returns can still attract investors.

Nephila Capital’s continued expansion into new and innovative ways to access the returns of catastrophe risks right throughout the insurance to reinsurance chain also demonstrates that ILS managers are not going to simply sit back and be disrupted, as perhaps could be leveled at some reinsurers.

Similarly the continued steady growth of ILS managers like Leadenhall Capital Partners, CATCo, LGT Insurance-Linked Strategies, Credit Suisse, Aeolus and Securis Investments (we could name more), all of which have broadened their remits and reach in the last year, also shows that many continue to succeed.

The report from Willis highlights one potential issue that is worth considering, as ILS funds become more like traditional reinsurance players are they at risk of losing the efficient edge they once touted and leveling the playing field between them and their competition?

Hearn explained this risk that ILS fund managers face in this challenging environment; “While this convergence trend is both logical and anticipated, it is creating a conundrum: as ILS funds evolve their business models to look more like traditional reinsurers, they are diluting the differentiation of the very offering which has proved so attractive to date for major primary buyers.”

It’s a valid concern. There is a risk that as ILS managers add more complex structures which require larger teams to manage them, increasingly underwrite complex collateralized reinsurance and do more and more private deals, they require more staff and skill sets internally.

That, if not adequately controlled, can increase their expense ratios and reduce the efficiency advantage that has enabled them to operate at a lower-cost of capital.

However, cost-of-capital is not purely based on expense ratios alone, it also needs to take into account the efficiency and return requirements of the underlying capital and here ILS can still display its edge.

Of course as reinsurance companies increasingly look to leverage ILS or third-party capital as well, with some managing it themselves, they are also able to benefit from this efficient capital.

So as ILS managers become more complex organisations and reduce expense efficiency as a result, traditional reinsurers are seeking to increase their capital efficiency and reduce their capital costs. Will the two strategies meet in the middle some day as a result?

We would venture that it is a much more difficult goal to reduce your cost-of-capital and increase expense efficiency when starting from a less efficient standpoint, than it is to grow, add staff and complexity while controlling efficiency and costs (which is what the ILS managers need to do).

But neither side faces an easy task. Reinsurers need to adapt and evolve in order to survive and thrive. ILS fund managers need to adapt and evolve in order to compete and grow. Neither task is a simple one, neither side are immune and both face increasing challenges as the market changes.

While both sides are technically at risk of market forces, there is perhaps another angle to this discussion, that of start-ups entering the reinsurance or ILS space. These ventures are in some cases perhaps best positioned to take the right path towards efficiency and lower-cost capital, without needing to adapt as much as existing players.

Could the ultimate winners be new entrants to the marketplace, be they absolutely new players, financed by existing players, direct investors with ILS models, or perhaps even the much discussed entry of the technology giants to insurance and reinsurance?

While nobody is immune to the effects of a softened, challenging and competitive reinsurance market, the fact we are going through structural change and a thorough reshaping does provide opportunity. Those brave enough to embrace new business models, or maintain efficiencies and who select the right path could find it a very good time to enter or grow in the market right now.

Also read:

April reinsurance renewal sees more rate declines, broader terms: Willis.

Subscale ILS funds may follow AQR’s lead, exit reinsurance: Moody’s.

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