28 November 2014ILS

In a state of flux

Insurance-linked securities (ILS) are nothing new. Having been around for some 15 years their use as a risk transfer mechanism is well understood.

However, as this form of risk transfer increasingly encroaches on the traditional business model, it is also evolving to find a new place and new role in the market. Most pertinently, more and more reinsurers have launched their own vehicles designed, in various ways, to tap into this new source of capacity and leverage it for their own purposes using their own expertise.

This dynamic is particularly relevant to Bermuda, which as a leading ILS domicile, has seen many reinsurers with significant catastrophe reinsurance books of business establish ILS platforms to manage third party capital (see Table 1).

“This can’t-beat-them-join-them approach is allowing traditional reinsurers to leverage their expertise and relationships in order to attract capital to their platforms,” says André Perez, CEO of the Horseshoe Group.

“While some of those reinsurers do it better than others, part of their operational fundamentals is shifting to become essentially a managing general underwriter on behalf of third party capital.”

In an Aon Benfield Securities ILS report, Bryon Ehrhart, CEO of Aon Benfield Americas, said that the broker had also witnessed an uptick in reinsurers actively working to incorporate alternative capital into their capital structures and improve their value propositions.

“Alternative capital providers have now built their own traditional-style vehicles and they add materially to the competitive landscape. The lower return requirements of the alternative capital vehicles have greatly reduced the cost of reinsurance for our clients,” he said.

The worldwide catastrophe reinsurance capacity is estimated to be around $300 billion. Within this figure, the top 10 ILS funds, including the likes of Nephila Capital and Fermat Capital Management, command roughly $35 billion of capacity, which equates to about 12 percent.

With ILS predicted to control at least one third of the total cat reinsurance capacity within the next five years, it is easy to understand why so many reinsurers have been quick to adopt new practices.

“The fact that so many Bermuda companies now have an ILS platform is a reflection of how deep the impact of the capital market has been on the reinsurance industry. An antagonist will tell you that after interest rates go up or there is a big market loss, all this ILS money will leave, but I can assure you that that is far from reality,” says Perez.

Sculpting the future

As the acceptance of this alternative capital grows, knowing the reasons behind its growth is paramount to understanding its long-term existence within the industry.

In 2005 hurricanes Katrina, Rita and Wilma (KRW) hit the US and caused billions of dollars of insured losses, events which changed the course of how catastrophe reinsurance would be transacted in the future.

“We believe this next wave of alternative capital will drive consolidation, share repurchases and special dividends.” Bryon Ehrhart

“Between the end of 2005 and mid-2007, a plethora of sidecars were formed. These fully collateralised vehicles essentially piggy-backed on the expertise of known reinsurers and gave an opportunity to fresh new capital (mostly hedge funds) to take on pure underwriting risk. During that period, close to $9 billion of new capital was raised through sidecars,” Perez says.

“Aside from obviously capitalising on reinsurance rates, which skyrocketed post-KRW, investors discovered a class of assets with the unique characteristic that it had very low correlation with the rest of their investment portfolios, and therefore was providing diversification.

“This is still what motivates investors to make investments in ILS today.”

Interest in the ILS space continued to grow throughout this period, resulting in a host of new ILS fund managers which, Perez says, “completed the three main pillars of the market: catastrophe bonds, sidecars and collateralised reinsurance”.

Michael Popkin and Rick Miller, managing directors—co-heads of ILS at Jardine Lloyd Thompson Capital Markets, agree. “As the capital markets have continued to grow, cedants have begun to see ILS funds as long-term partners. With the ILS funds developing more flexible mandates, it has meant that ILS funds and cedants can expand the relationship beyond just a cat bond transaction,” they explain.

In 2007, rates began to steadily decrease which caused the gradual disappearance of the hedge fund investors. However, the reduction in hedge fund investors paved the way for a new wave of interested parties: the pension funds.

Looking forward

Now, over half way through 2014, which has been one of the most successful years in the history of ILS issuance, predictions for the market’s future are bright.

“The development of the market over the next five years is still sensitive to significant catastrophe events. Last year we shared our view that another $100 billion of alternative capital will enter the market over the next five years and it will be far more transformative than the first $50 billion has been to the reinsurance market. We now believe this estimate is conservative,” said Ehrhart in the Aon Benfield Securities report.

“We believe this next wave of alternative capital will drive consolidation, share repurchases and special dividends.”

He also spoke of the company’s longer term views. “Our 2020 view shows a maturing relationship between a consolidating reinsurance market and investors that seek returns from taking risks that are not tied to credit, interest rate or equity market risks.

“This maturing relationship will incorporate around $150 billion of catastrophe bonds, sidecars, collateralised reinsurers and hedge fund-managed insurance and reinsurance companies. Reinsurers will have a more consistent value proposition for insurers because they will have incorporated the accretive alternative capital,” he said.

However, as Perez explains, the traditional reinsurance model has been irreversibly changed.

“The real problem for traditional reinsurers is that the oversupply of low-correlated capital is driving the reinsurance rates down.

“Conversely when the ‘big one’ happens, there will be such an influx of new capital from ILS investors, the chances are that the reinsurance rates will not increase post-event as much as they have in the past. The usual catastrophe pricing cycle is changing shape, with deeper lows and much lower highs. Not exactly a compelling proposition for shareholders of a traditional reinsurer,” he says.

“Adding insult to injury, ILS investors are now expanding their investment beyond property catastrophe reinsurance. They are now allocating assets to lines of business such as terrorism or crop, and are also investing directly into insurance companies and corporate programmes.”

While there is a more unified acceptance of the longevity of alternative capital and the increase in ILS activity, there are some who are still waiting for the capital to shrink back to its previous existence.

But as Perez concludes, regardless of the capital, “One thing is for sure: the traditional reinsurance model has been permanently altered and is now in a state of constant mutation.”