14 October 2013

Convergence capital: no passing fad

What was this year’s hot topic in Monte Carlo?

Predictably alternative capital flows into the reinsurance sector dominated many conversations and once you filter through many now jaded perspectives on cannibalisation, there are some key views forming that could shape the future of the risk transfer sector.

First, while on the margins some new capital might have a shortterm component, the majority is likely to be long term in nature. Many commentators talk of the impact of interest rate increases and the potential outflow of capital as a result, but many of the new investors are pension funds with a long-term allocation view. And perhaps even more importantly, the discussion needs to focus on spreads not rates, with the former needing to move considerably before the attractiveness is diminished to the point of exit. In the main, investors are familiar with the sector and specifically the chance of full loss of principal and hence the absence of a path to recovery.

Second, for certain risks, risk managers are unified in seeing ILS as being complementary to traditional products with the two serving to enhance their ability to hedge risk more efficiently. Reinsurers are almost unified in seeing the flow of capital into the sector as an opportunity rather than a threat. Questions are being raised overthe optimal structures needed to capitalise on this capital while still preserving broader objectives around policyholder protection over the long term; with all opportunity, however, solutions are there to be found as the market evolves.

Third, the sector will continue to lag if the focus remains on fierce competition around existing capacity and growth in the supply of capital, rather than innovating to increase demand for risk transfer solutions. This is a complicated situation—solutions do need to be found if there are potential structural issues—but risk will be transferred to counter parties that offer the best overall value equation whether that is driven by capacity serviced by lower cost of capital providers or multi-dimensional carriers. If margins are shrinking in existing lines, the risk transfer market must find ways to source new demand profitably.

Finally, while it is expected that the supply of new capital will continue to grow, the ILS market remains at about 15 percent of the overall reinsurance capacity and so both it and the remaining 85 percent of reinsurance has great potential to grow symbiotically. At PwC, we see tremendous opportunity for innovation in both developed and emerging markets.

Are you surprised by how fast ILS is growing?

No. First, I tend to look at the provision of risk transfer or risk financing solutions as a whole. ILS in my mind reflects positively on the underlying innovation that sits within the reinsurance market and which helps to enable the market to position itself well against the constantly evolving expectations of stakeholders. Further, it points once again to the significant intellectual agility and innovation which resides in Bermuda, now the world’s undisputed leader in the development and provision of alternative risk transfer solutions including ILS.

Clearly, the search for uncorrelated returns has been one of the key catalysts for investor interest. But the demand that ILS fulfils and its impact on the broader reinsurance market go much further than short-term yield. Risk managers have been blending alternative and traditional products to hedge risk for almost two decades now and the resilience of the catastrophe bond as an example has been demonstrated.

You mentioned that you see the new capital entering the sector as long-term. What supports your viewpoint?

Much of the supply of new capital is from pension funds who like the advantages they derive from this asset class in the form of spread, standard deviation and non-correlation. I believe the capital is long term for the following and fairly straightforward reasons.

While for some pension funds, their investment may be 1 percent of 1 percent of the overall fund, we have observed the most rigorous and time-consuming due diligence being performed before any investment is made. In some cases this has involved in-sourcing the expertise required to provide direction and oversight over a fund’s allocation to reinsurance. This alone does not indicate an investor class in a segment on a whim.

Another key reason relates to pension funds. They have different objectives around return and are not in the market for fast yield. Last, and perhaps most significantly, there appears to be some confusion about the impact that a changing interest rate environment will have on allocations to reinsurance—that there will be a ‘sucking noise’ as capital washes out again. In my mind, investments have a lot more to do with the relative width of spreads than they do with yields generated by ILS versus other asset classes. Spreads would have to move quite a long way before a pension fund investing in catastrophe bonds view their investment as being inconsistent with their underlying objectives for their allocation to this class.

I would make two further observations. It is important that policyholders do experience stability of expectation around pricing, security and service over the long run, so having investors in the space that mirror those objectives is key. Participants in the market (whether traditional or alternative) need to have that capacity being consistent over longer periods. Further, there has been a reasonable degree of commentary about naïve capital over the last 12 months. It is critical for the ILS sector to continue to be focused on providing sufficient transparency to investors about the risks they are investing in, the possibility and magnitude of loss and how that is calculated. ILS has significant and well educated investors, but it is important for those that may be new to the sector to be well appraised of the risk component of risk-adjusted returns.

What happens in the event of a market-changing loss?

Again, I understand the point of view, and certainly this asset class presents less of an opportunity for ‘recovery’ than other classes given the nature of the underlying risk being property catastrophe. In the main, however, we are talking about sophisticated investors here who have done their due diligence. Many won’t partner with a sidecar counterparty unless they have contractual agreement that they can ‘re-load’ their investment post-event.

I don’t necessarily see a massive distinction between the potential for cover to be retracted or amended post-event between traditional or alternative capacity, albeit one is driven by the decisions of a company acting on behalf of shareholders and one is purely an investor-driven decision. On this basis there could be movement of investments out of the sector if significant harm is done to principal, but I would see that being the action of a minority.

What do you see as the most important developments in the ILS market over the past 12 months?

I like to view the market in the aggregate. While Goldman Sachs recently identified ‘alternative capital in reinsurance’ in its published list of the eight forces which it believes are most likely to disrupt business, I tend to see it as an opportunity that can and will be harnessed. The risk transfer market is firmly in the spotlight and it needs to capitalise on this and the supply of capital in a sensible and long-term fashion. This longevity and stability is of such fundamental importance to insurers and again speaks to the importance of structure and market order as capital is introduced.

This is applying increasing pressure on brokers, reinsurers and alternative fund managers to innovate and attract new demand flows into the sector. Frankly, this is what they are good at. Looking at innovation within existing capacity, brokers and fund managers have worked together to provide country-weighted index products that help narrow basis risk for cedants while being deployed cost-effectively. Along these lines, reinsurers are providing transformer services essentially running a basis risk arbitrage to make margin.

Outside existing capacity, new cedants are being attracted to the space (so expanding aggregate capacity) as reinsurers innovate around their core proposition. There has been an increase in the number of private deals conducted outside the syndicated markets showing that the risk transfer proposition can connect with a broader demand base if certain hurdles are met. Nonetheless, there is a vast amount ofopportunity remaining to be tapped and there has to be a fundamental shift in gears within the whole sector to innovate and grow.

You talk of the potential for structural concerns being expressed? Would you elaborate on this?

Critical risk selection, technical pricing and policyholder protection represent the fundamental building blocks to building value and prevailing over the long term. Whether an underwriter aiming for budgets, or an asset manager deploying mandates for a fee, long-term success for businesses, investors and shareholders will only manifest from a focus on these building blocks.

Questions were raised in Monte Carlo about whether investors in ILS were too far removed from the preservation of long-term interests of policyholders. This is an interesting point when collateral is placed in trust for the benefit of the policyholder. I suspect the thrust of the question is driven from a concern that if the capital behind the risk is too passive and disconnected from the risk or is short term in nature, it diminishesfocus on the building blocks.

"It is critical for the ILS sector to continue to be focused on providing sufficient transparency to investors about the risks they are investing in in."

I agree absolutely 0n the importance of these building blocks. What I don’t see as clearly is the distinction between alternative and traditional risk transfer when it comes to the importance of focusing on them. Nor, when I look at the sophistication of a number of dedicated fund managers or investors in ILS, do I see an erosion. The industry must move together to ensure that its structural—and indeed philosophical— approach to risk transfer is consistently robust; whether that is further enhancing obligations around collateral, improving the transparency of information and analytics from the insured, all the way through to the retro markets, or introducing mechanisms that better support discipline when competition is at its fiercest.

What do you see as the most important priorities for the market?

Beyond the building blocks, it comes down to increasing demand. Rather than fighting over existing capacity, it’s vital that both sponsors and investors seek to expand the aggregate size and potential of the market.

With the principal focus continuing to be wind and earthquake exposure in the US, reaching into the areas of European wind and Japanese earthquake offers considerable scope for growth. The fast growth emerging markets also remain largely untapped, with the potential to attract sovereign wealth and other sources of local capital. The barrier at present is the lack of the necessary risk data to ensurepricing accuracy and adequacy. This may in turn demand a shift in personnel and modelling focus from the well-analysed developed market risks to those in the emerging markets.

It’s also going to be important to look beyond property cat at other exposures that could suit ILS-type structures. Pandemic risk is an example. Extreme mortality bonds could offer more effective risk transfer, building on the wider capital market interest and investment in the catastrophe bond market.

Other new frontiers to be explored include cyber and longevity risks. Moreover, many governments can no longer afford to be the reinsurer of last resort in areas such as flood and terrorism cover and may look to ILS to absorb some of this risk. This would open up hundreds of millions of dollars of capacity. Bringing more quake capacity to the market in California at accessible levels for potential insureds is another example of building capacity in established markets.

In the short term, encouraging investors to reach into new geographies and risks may be a challenge. But as more capital moves into the market, investors may need to accept new types of risks or more extreme risks to maintain their target yields.

The need to make the most of these opportunities is going to put innovation firmly at the forefront of market development. As the premier centre of innovation and development in the ILS market, this bodes well for Bermuda.

Ultimately, it’s important to look at ILS in the context of the development of the broader reinsurance and risk transfer market. Traditional and alternative capacity has an important and complementary role to play in providing more effective risk management solutions and meeting more exacting stakeholder expectations.

What is your outlook for the market?

There is considerable opportunity for those that can attract exceptional talent and assimilate big data and analytics to innovate. These innovators will enjoy unparalleled access to new and diverse ‘blue oceans’ and be able to deliver value at great margin.

Does Bermuda have a key role to play in this?

Absolutely. The domicile is a seed bed for innovation and adaptability. Much work has been done and continues to be done to push the debate forward and create the right platforms for growth. In November, Bermuda plays host to some of the world’s leading investors and fund managers, reinsurers and deal makers in an exclusive event to do just that. Convergence 2013 is designed to develop ideas and solutions to further evolve the market in creative and sustainable ways.

Arthur Wightman is partner—insurance leader at PwC. He can be contacted at: arthur.wightman@bm.pwc.com