Will pension funds, alternative capital & ILS kill the reinsurance cycle?

One of the topics that has been heavily debated over the last few years is exactly what the increasing amount of pension fund investments in ILS and alternative reinsurance capital means for the traditional reinsurance market cycle.

Will the reinsurance market still see a cycle, as we have come to know it, in the years to come? Has it already been smoothed by the approximately $60 billion of third-party or alternative capital already invested in insurance-linked securities (ILS), catastrophe bonds and collateralized reinsurance? Will more capital flowing into the market after the next major loss events maintain the softness in reinsurance rates that we are currently seeing? How will this market look ten or twenty years down the line?

So many questions.

The consensus seems to be that for the moment, while alternative capital remains a smaller portion of the market largely devoted to property catastrophe reinsurance where it makes up as much as 20% of that market niche, we will still see a reinsurance cycle emerging post-catastrophe event.

But this cycle, particularly in property catastrophe reinsurance, may be much less pronounced than reinsurers have become accustomed to, leading to much more stable prices and rates. In other lines of business where ILS and alternative capital have yet to find a meaningful way to enter the market, it is expected that the cycle will remain albeit less pronounced due to excess traditional reinsurer capital spilling over into these lines looking for opportunities.

But what happens next for the reinsurance cycle?

The reason that question is particularly difficult to answer is that we are still only in the early days of the ILS market and the convergence of capital markets money with reinsurance capacity.

While the ILS market has been around for approximately 20 years, it is really only in the last two or three that ILS capital has begun to grow much more rapidly, that investment managers have become much more sophisticated competitors to traditional reinsurers and that the insurance-linked asset class has begun to get serious attention in wider investor circles.

If we’re still in the early days of the capital markets interest in accessing the returns of the insurance and reinsurance market, as well as direct catastrophe risk transfer and financing, it suggests that we have a long way to run and that the impact on the traditional reinsurance market cycle has only just begun.

At an event held in New York yesterday by Trading Risk, Paul Schultz the CEO of Aon Benfield Securities, said that global pension fund interest in insurance-linked securities (ILS) and reinsurance as an asset class has only just begun. Many large pension funds remain interested in the reinsurance space, as well as insurance, and the entry of pension fund capital has perhaps only just started to affect the re/insurance market.

As we’ve written before, total pension fund assets around the world amount to trillions of dollars and, with the ILS and reinsurance space currently only having a very small proportion of this allocated to it, it stands to reason that we will see continued growth in assets allocated from pension funds to ILS.

It’s widely understood that pension funds who invest in ILS tend to allocate around 2% to 4% of their assets into ILS and insurance-linked investments such as catastrophe bonds, as a diversifying asset offering an attractive return with very low correlation to wider financial markets.

This understanding and appreciation of the asset qualities that can be found from investments in reinsurance and ILS is still spreading. Pension funds are increasingly discovering the ILS space, learning about it, meeting market participants and investment managers, gaining an appreciation for ILS as an asset class, after which they typically begin to make plans to allocate to the space. It’s not a quick process for pension fund managers to get comfortable with a true risk asset like ILS and especially catastrophe risk assets, nor to secure approval to allocate to it from your investment board.

For every pension fund that is already invested in ILS there are likely at least 10 others who have discovered the asset class and put some effort into understanding it and gaining an appreciation of it. For each of those there may be 10 more pension funds who have heard of it but not yet put any significant time into learning about or analysing ILS yet. For each of those there could be 10 (or more) others who haven’t yet even really heard of ILS or instruments such as catastrophe bonds. That suggests this trend will continue to run.

Schultz said that many large pension funds continue to show their interest in investing in the ILS space, with research that his firm undertook showing that many are either ready to enter the ILS space or showing increasing interest in doing the diligence necessary to gain an appreciation of the asset class and the ILS investment managers working in it.

Schultz also insinuated that it was important not to pigeon-hole ILS and alternative capital as solely interested in reinsurance risks. He said that increasingly ILS investors want to target directly insuring corporates and growing the market outside of purely providing property catastrophe protection for insurance sponsors.

The ILS market has always done this, provided risk capital directly to corporates, with catastrophe bonds as far back as 1999 directly providing risk transfer and capital to corporate cat bond sponsors. However this has always been a very small part of the market, but with an expectation that it will grow.

The desire to grow the ILS market outside of the narrow areas of U.S. property catastrophe risks, with a small amount of risk from Europe and Asia included, is clear among both investment managers and with the ILS investors, such as pension funds, themselves.

It is only a matter of time (in our opinion) until large corporates with natural disaster exposure begin to look much more seriously to the contingent and predictable post-event capital injection that instruments such as parametric catastrophe bonds can provide.

Back to the cycle. If we now have a reinsurance market cycle which is expected to be less pronounced, due to lower cost efficient capital from ILS investors, a diminishing willingness (perhaps) to support concepts such as reinsurers expected payback, more capital on the sidelines  expected to flow into the market after events, plus even more interest being shown by an increasing number of pension funds, are we witnessing a new normal?

We would suggest so. There is no suggestion that pension fund capital will seek to pull-back from reinsurance, catastrophe risk and insurance-linked investments. In fact, every sign is that this capital will increase and at the same time even traditional reinsurers will find new ways to bring more efficient capital and structures to bear on property catastrophe risks and into the insurance market.

If capital has created the softness in the reinsurance market that we currently witness, then having even more capital can only flatten the cycle even more, can’t it?

There’s an important distinction to be made between softening of prices and flattening of the cycle.

Continued flattening of the cycle does not necessarily mean ever cheaper insurance and reinsurance prices. Rather, the new capital providers such as pension funds and ILS investors, as well as the next generation of insurers and reinsurers (which will exist, but likely with new, more efficient and innovative business models), will gain a better appreciation for their cost-of-capital allowing them to establish pricing floors.

At the same time, as technology advances, models become better and investors and investment managers become ever more sophisticated, there is an expectation that their understanding of the cost of risk, therefore what they need to charge to provide risk capital, will become increasingly sophisticated and more accurate. That suggests a much flatter cycle, perhaps with what cycle is left driven purely by demand or a change in risk profile in the future, rather than capital supply.

Some in the ILS market are even more bullish than us on the future for the reinsurance cycle and ILS capital’s influence on it.

At the same Trading Risk event in New York yesterday, Dr. John Seo, co-founder and managing principal at ILS investment manager Fermat Capital Management, made an interesting comment; saying that even alternative capital will soften and that in the end it will kill the reinsurance cycle.

ILS capital and huge global investors like pension funds do have the potential to kill the reinsurance cycle, if they poured capital into the space. At that point we’d expect the traditional reinsurance model would become unviable, at least in some areas of the reinsurance market like property catastrophe, as direct capital and ILS driven business models took over.

That could really happen and some people, like Mr. Seo, clearly believe this is a possible outcome of these trends we have been witnessing in recent years as the ILS market grows. Disruption and a restructuring of the reinsurance industry is clearly underway and will continue to be driven by efficiencies in capital, technology and our understanding of risks.

The end result of course is still risk transfer, risk financing and risk capital, just perhaps not as we know it today and that means the reinsurance cycle (or what is left of one) will be very different in the future.

More reading:

– Innovate or perish. A message for insurers and reinsurers from Aon.

– A smarter, more client-responsive reinsurance market: Willis Re.

– Differentiate or consolidation ahead for reinsurance industry: PwC.

– Innovate & adapt to navigate a reconfigured reinsurance industry: S&P.

– Structural change, lower margins, a deeper reinsurance convergence.

– The death of the traditional catastrophe reinsurance model.

– Institutional investor appetite for insurance linked assets remains strong.

– Pension funds still only dipping their toes into ILS and reinsurance.

– Still early days for pension fund allocations to ILS and reinsurance.