Swiss Re Insurance-Linked Fund Management

Original Risk: A Society for Change Agents

Risk bundling driven by traditional reinsurance market: Twelve Capital


The recent discussion of risk bundling has been wrongly aimed at the insurance-linked securities (ILS) market, according to Zurich headquartered ILS manager Twelve Capital, which points out that self-regulation is actually very strong in ILS.

“The issue is that as the ILS market has been targeting better paid risk, traditional reinsurers have begun to offer multi-line aggregate reinsurance deals (several separate portfolios covered by one tranche of indemnity instead of a separate protection for each, as is the norm),” the ILS fund manager explains.

This bundling up of multiple reinsurance treaties into a single package has been touted as the centralisation of reinsurance buying, but clearly different ceding companies are taking this idea to differing levels.

The very largest insurance buyers are centralising across geography and line, but many keep a level of separation within their programmes in order to allow markets easier access. These cedents are aware of the importance of maintaining a level of diversification among their reinsurance counterparts and sources of risk capital.

Others, however, are not and have bundled as much as possible into a single portfolio that they then attempt to transfer to reinsurance markets. Here the cedents actually put themselves at heightened risk, as they can erode these new covers quickly without maintaining protection for future events.

Twelve Capital explained; “This means that a primary carrier may find reinsurance protection exhausted by adverse results in a single line leaving them without cover for other lines. Also, monoline cat aggregate XL may be eroded in total by a single event leaving an insurer without protection for a second event.”

These issues, which do result in a packaging of risk to a degree where it becomes more complex to assess and understand, are not issues of the ILS market’s making, Twelve Capital say.

“Both of these issues are driven by the traditional market and are very much the choice of the primary insurer,” the ILS manager continues. “At present, the ILS market tends to avoid these risks as it does not fit risk management guidelines well.”

In fact, Twelve Capital believes that there is already some shift back away from this trend, suggesting that the market has tried it, found it not to be the most efficient way to transfer its risks, and is now reversing away.

The ILS manager explained; “The market as a whole is already realising the issue and is moving away from the problem. This self-regulation as a market is actually very good these days.”

Twelve Capital also noted that the level of discipline and scientific rigor in the ILS market is particularly high.

“It is true that in the past, ILS funds were sometimes run by managers who had no reinsurance experience and did not understand the nature of the underlying risk. Today, most funds now employ staff from the reinsurance sector and are managing risk with long experienced personnel,” Twelve Capital said.

And with respect to claims that ILS market participants rely too much on risk models, Twelve Capital puts forward an interesting view-point. That it is far superior to operate a market that relies on the collective scientific experience and wisdom of hundreds or thousands of scientists, than say a Lloyd’s syndicate box with a single underwriter.

“We would argue that for the studied perils the models now represent a good quality of science. A traditional underwriter will add a layer of common sense to modelled results, interpret additional financial needs of the risk carrier and interpret information feeding the models. Overall it is better as a market that we rely on the collective experience of hundreds of scientists employed by the modelling agencies rather than the small teams any reinsurer can employ or the gut feel of one person sitting at a Lloyd’s Syndicate, as in the past. The level of scientific debate in the market is of a very high level,” Twelve Capital explained.

There is without a doubt a danger in any financial market that underlying risks could become obfuscated or difficult to define, particularly when a market tries to package risks. This is where self-regulation becomes vital, as well as the discipline of the managers working to provide sector access to investors and of the brokers proposing new deal structures.

With ILS managers increasingly moving to collateralised reinsurance in order to better returns and access a wider slice of the insurance and reinsurance market, this discipline becomes ever more vital in order to maintain the efficient edge that ILS has today.

Any slip towards indiscipline would result in losses, which would very quickly send the type of sophisticated institutional investors that allocate to ILS and reinsurance running from the sector. Therefore it is in the market’s interest to remain disciplined and ensure no undue risks are introduced.

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