Naivety in the ILS space must be avoided

There is a question mark as to just how well informed the capital market investors now entering the reinsurance space are, and it is an issue that divides opinion, with many claiming the market will truly know only after a big loss.

As Larry Richardson, senior vice president at Arch Capital Markets, pointed out, the vast majority of alternative capital is lucky to have entered the property cat market during a run of benign weather years during which industry cat losses have been well below modelled levels.

“This has led many investors to expect high profits and that a given investment will roll from one year to the next, like purchasing a series of short-term bonds,” he said.

The influx of alternative capital into the reinsurance space has raised many questions, the biggest of which remains unanswered: does this alternative capital really know what it is doing, and how will it respond to the big losses that will inevitably come?

“We suspect that there are many investors who have not focused on the reality that models are imperfect and that a large event can cause a total loss. We also wonder whether investors are clear that while the exposure period may be one year, even if not ultimately used to pay losses, their capital may be retained for a number of additional years as losses develop.”

The speed and enthusiasm with which the capital markets have entered the reinsurance space may be evidence of naivety but it is important to view it in the context of the size of the capital market as a whole.

“Personally, and broadly speaking, I don’t think it’s naive at all—the capital market as a whole is  much larger and  much more efficient, and it’s a tough place in which to operate,” said Paul Markey, chairman of Aon Group (Bermuda).

“Most of the people from the capital markets who are looking at insurance objectives have accomplished an enormous amount in their own right. It’s natural for them to look at opportunities in our sphere.”