The flood of alternative capital into the reinsurance sector through structures such as insurance-linked securities could well change the industry beyond recognition. But there are a number of scenarios that could interrupt the flow of this capital into the market, argue Jason Carne and Bill Miller of KPMG in Bermuda.
While the received wisdom in the reinsurance industry right now is that alternative capital is here to stay there are, in fact, some circumstances that could lead to at least a partial reduction in its interest in risk transfer as an investment opportunity—which could lead to rates hardening as a result.
That is the view of Jason Carne, managing director and head of insurance-linked securities (ILS), KPMG in Bermuda, and Bill Miller, managing director, KPMG in Bermuda. They stress that many of the investors in ILS are now run by sophisticated and seasoned executives who understand the nature of ILS—and its inherent risks. These will not easily be put off investing in the space.
But they also believe the industry should consider the potential implications of a number of different scenarios in the context of how investors who can easily exit the industry could react.
“The first and most obvious would be a big loss, triggering a number of bonds,” says Carne. For this to have any noticeable impact, he believes, it would have either to be very big or there would need to be a succession of big losses.
“The fact is that even a one-in-100-year event doesn’t seem to move the needle on rates these days,” he says. “It would need to be a lot bigger than Katrina.”
If the event was big enough, Carne does believe some less sophisticated investors could flee. They would, however, quickly be replaced by what he calls very savvy investors waiting on the sidelines, which would quickly fill any void.
“The question then becomes a matter of timing,” he says. “Even new reinsurance companies can be formed quickly these days but the speed with which alternative capital can enter a market through collateralised structures such as ILS is even greater again. The cat market is much more nimble as a result.
"Access to the site has been limited and insurers and reinsurers facing claims will not have the level of information they would normally expect following a large loss of this nature." Bill Miller
“This means there is only a very small window of opportunity for rates to harden and it may hardly be called a window at all. Yes, capital would leave but it would also be replaced again very quickly.”
One byproduct of this which could encourage a hardening of rates, he notes, would be if an element of under-insurance emerged post a big event. This could encourage insurers to buy more coverage, potentially leading rates to rise. “A spike in demand would also harden rates,” Carne says.
Greener grass elsewhere
The second scenario he considers is the emergence of more lucrative investment opportunities outside the risk transfer business—something that could, in part, be triggered by a steepening of the yield curve in interest rates.
“Some money would certainly leave the market if there were better opportunities elsewhere,” Carne says. “We have already seen that happen with some hedge funds, which seem to take the view that they have made the good money and will seek other opportunities now rates have softened.”
But he also stresses that this will affect only a certain portion of the market. Many of the biggest investors such as pension funds fundamentally like ILS because it offers them diversification.
“Hedge fund money is clearly more opportunistic but there is also a hard core of pension and institutional investors who are here for the long term,” he says.
The next scenario that could disrupt the market could be a high-profile legal dispute whereby a cedant ends up not being paid after a triggering event. There could be numerous reasons for this, including legal disputes or allegations that the risks were not fully disclosed. Carne stresses that such a scenario could make cedants question using this form of risk transfer.
“Disputes over claims are nothing new to the traditional industry but they are rare in the still relatively new ILS market. If something like that did happen, it could give buyers of coverage cause for concern,” he says. “I think it would continue to grow after such a scenario but maybe not as quickly as it is now.”
A related risk could be that either investors or cedants lose faith in the risk modelling technology that is so important to ILS. Even if there were no dispute over the claim itself, the emergence of a loss event that has not been factored into the loss scenarios could cause significant disquiet in the markets.
“If investors felt the models were inaccurate or misleading in some way, that would be a big problem for the market,” he says. “Most investors are sophisticated and they fully understand the risks. But if they felt something substantial had been missed, they would be disgruntled.”
Miller at KPMG Bermuda identifies a number of other scenarios involving emerging markets and the way they use the ILS markets.
First, he frames a scenario in which an economic powerhouse such as China opts to use ILS as a risk transfer tool on a large scale. The nation recently completed its first catastrophe bond, Panda Re, giving it a toe in the water, but its potential to transfer more risk is potentially vast.
“Most investors are sophisticated and they fully understand the risks. But if they felt something substantial had been missed, they would be disgruntled.” Jason Carne
If this were to happen, perhaps combined with similar strategies from other emerging markets, this could dilute the competition for existing ILS deals covering peak perils in the US or Europe. In turn, rates could harden in both ILS and traditional lines.
“It depends on whether certain governments were to embark on a strategy to offset more risks,” Miller says.
“That would alter the supply into the market. If demand for these bonds did not increase at the same pace, that could put pressure on rates. It is an unlikely scenario but not one that is beyond the realms of possibility.”
He also notes that other forms of uncertainty can exist in some emerging markets, which could make them less appealing to investors.
“Following the August explosion and subsequent loss in the Chinese port city of Tianjin, access to the site has been limited and insurers and reinsurers facing claims will not have the level of information they would normally expect following a large loss of this nature,” he says.
“This is the type of event that can happen in emerging markets—things do not operate as investors might expect. It might not scare them off such investments but it might mean they want a higher return for the uncertainty and mean they would rather use parametric triggers, based on indisputable measurements such as the Richter scale.”
Jason Carne is a managing director at KPMG in Bermuda. He can be contacted at: firstname.lastname@example.org
Bill Miller is a managing director at KPMG in Bermuda. He can be contacted at: email@example.com
Jason Carne, Bill Miller, KPMG, Bermuda