28 November 2014ILS

Strong alternative capital growth increases competition

Through June 2014, Standard & Poor’s Ratings Services rated $3.4 billion of natural peril catastrophe bonds (cat bonds) and outstanding issuance stands at $23.06 billion. With the increase in supply, pricing is falling, and old and new issuers are taking advantage.

The property-casualty portion of the insurance-linked securities (ILS) market primarily consists of natural catastrophe bonds and is a small part of the alternative capital markets that are putting pressure on the traditional reinsurance market. Alternative capital comes in several forms and sizes, most of which are private transactions that are not easily tracked. Estimates from Swiss Re, Aon plc, and Goldman Sachs & Co put this capital at over $50 billion, and they expect this figure to double during the next five years.

We believe that the alternative market will continue to grow, but not at expected rates. Traditional reinsurers still offer advantages to their clients in terms of efficient execution, long-term relationships, reinstatements, and consulting services and it will be difficult for alternative markets to compete with their distribution capabilities. Instead of fighting the rising tide, we believe reinsurers should be taking advantage of the available third-party capital and look for the most efficient way to manage their risk portfolios.

In our view, growth in the alternative market should not come from less-diligent underwriting (such as expanding protection to include risks that are hard to quantify and may contribute significantly to the likelihood of losses) or ventures into new products that do not match investors’ investment horizons or liquidity needs (eg, casualty or longevity risks) just to put their assets to use.

For S&P, underwriting discipline in the alternative market is already a concern, especially for cat bonds. When investors provide protection to a cedant on an ultimate net loss (UNL) basis, the investors must, similar to reinsurance underwriting, be diligent in adequately pricing the risks they are assuming.

Most deals issued so far in 2014 have been on a UNL basis or, in cat bond terms, have used an indemnity trigger. Cedants prefer indemnity triggers because it reduces their basis risk. Investors are exposed to the risks inherent in the underwriting and claims processes of each cedant. This requires participating investors to have a detailed understanding of the cedant’s business. Available data must also be complete and of good quality. As the alternative market moves more and more into writing UNL and away from parametric or modelled loss trigger covers, questions are surfacing as to whether investors have the same level of underwriting expertise as traditional reinsurers.

Scope to grow

Still, we see scope for the market to grow through an increase in take-up rates in the direct insurance markets. This in turn will lead to higher demand for reinsurance in catastrophe-prone areas. Cat bonds may help governments both reduce their reliance on disaster funding and provide protection for areas exposed to natural catastrophes. Properly structured joint ventures between strong underwriters and alternative capital providers such as hedge funds could provide further growth opportunities.

So far the alternative market has not been tested by a major catastrophe. How this alternative capital will react depends on whether event-based losses occur as expected, the available yields in other asset classes, and the balance between short-term opportunistic investors and longer-term players, such as pension funds, affected by the losses. If the balance leans toward long-term players, we believe they could easily absorb a full-limit loss within their investment tolerance because they are investing only a small portion of their funds in this sector or in the case of dedicated, cat funds, this is their business so they expect losses periodically.

Because rates would likely harden a bit after a major catastrophe, perhaps less drastically as past price increases, one or two major event(s) could draw in more capital.

“Cat bonds may help governments both reduce their reliance on disaster funding and provide protection for areas exposed to natural catastrophes.”

Such a large amount of alternative capital coming in on top of record levels of traditional capital in the reinsurance market has led to competition between the traditional reinsurance market and the alternative market and among alternative capital-market participants themselves. Specialised ILS funds are driving some of this competition. As the increase in supply pushes down yields, specialist ILS fund managers have set up new funds with lower targets to employ their available capital at current pricing levels and continue to compete under current market conditions. This could mean that without a major catastrophe event, pressure on nat-cat prices could continue.

As the competition increases, terms and conditions on the cat bond side are broadening. The question is whether looser underwriting standards will hurt ILS investors searching for diversification and yield. During the past two years, new issuances provided some sought-after opportunities for investors to diversify their portfolios into non-US peak perils such as Japanese typhoon, Japanese earthquake, Turkish earthquake, European windstorm, Canada earthquake, Caribbean hurricane, and health claims payments.

Depending on the investor profile, geographic diversification is not always a necessity. In other words, almost all of the diversification benefit is already gained by entering the asset class even if it is regionally concentrated, leaving only marginal benefit for diversification within the asset class.

The sector’s recent growth may provide an additional avenue for capital to flow and more sources of reinsurance to primary companies at lower rates. We expect growth to continue, but not at the current rates. In our view, growth should come from various avenues such as increased take-up rates in disaster-prone areas, disaster protection purchased by governments, and product innovations through underwriting joint ventures.

The current competition among market players has been leading to a welcome reduction in prices and a loosening of terms for cedants. However, we caution that for the alternative market to maintain the credibility it has gained after all this time, growth should not come at the expense of looser underwriting discipline and less due diligence.