The architecture of modern capital
Many in the re/insurance industry are talking about an evolution in the sector as an increasing level of business—particularly in the property cat space—is being underwritten by alternative forms of capital. Collateralised re/insurers, insurance-linked securities (ILS) and sidecars are seizing upon perceived opportunities in the market, even as the soft cycle persists. It seems likely that these new plays will affect pricing and serve to mute any possible turn, but there is a grudging acceptance among reinsurers that they are now a part of the landscape.
‘If you can’t beat them, join them’ would sum up the attitude of some players, with more and more traditional reinsurers deploying portable forms of capital, even though the industry—in 2012 at least— faced no speciﬁc market dislocations. Bermuda Re talked with three members of its editorial board about the rise of portable capital and asked what is driving interest, whether it will be sustained beyond the current ﬁ nancial crisis and what effect it will inevitably have on more traditional players.
Alternative plays in the reinsurance area have been around for some time—with ILS issuance beginning to make waves back in 1996 (see table overleaf)—but they seem to have gained traction—and headlines—in recent months. A number of factors are playing their part. One of the key drivers has been the doldrums that the wider capital markets have found themselves in following the ﬁ nancial collapse of 2008. In search of returns, many investors have turned to reinsurance and the potential of quick forays into the space.
Paul Markey, chairman of Aon Benﬁ eld, spoke of rising investor interest in the collateralised space, indicating that “there is continued interest from investors to enter—particularly on the cat-side of the business—because the returns are interesting, and, in the case of US risks, they are well understood”. Markey said that a lot of collateralised cat business now falls into the alternative investment strategies of an increasing number of institutional investors. Hedge funds have led the charge, but increasingly other institutional funds are getting in on the act, regarding investment in reinsurance as a diversiﬁ cation tool, he said.
Markey added that such forms of capital “dovetail well with the pure ILS business”, providing clients with further options to hedge their risk. He said that investors were pleased to have the choice of products offered by the alternative market, from industry loss warranties to parametric triggers and indemnity deals. He added that with the help of models, ILS-type products are becoming increasingly understandable to the wider investment community, with portable capital representing a “potentially neat addition to their wider portfolio”.
Mark Watson, president and CEO of Argo Group spoke in a similar vein, indicating that the supply side has been driven by rising involvement in the space as institutional investors have sought to “broaden their asset portfolio, viewing ILS as a way of taking on insurance risk, but in a more speciﬁc way”. Markey did however raise a concern, namely: “the willingness of investors to pay claims and re-enter the marketplace post-event. That part of the test will be very closely watched”. Investors presently on the sidelines are waiting to see exactly what will happen when a major event hits the ILS space, Markey said, with the suggestion being that depending on how events and their implications for ILS products pan out, investors will either be attracted to, or withdraw from, the space.
There have been few major tests to-date, with only a limited number of ILS having been triggered, but as the market grows, more bonds will inevitably be triggered and—in some instances—potentially in correlation. A major correlating event will prove a litmus test, but there is already conﬁdence within the industry that portable capital will continue to be an attractive choice to investors looking for a hedge against the capital markets.
Helping to drive the involvement of new capital were concerns expressed following the ﬁnancial crisis about the solvency of global insurers and the retrenchment of the reinsurers. “The crisis raised concerns about insurers’ ability to pay claims, while reinsurers retreated from certain risks and exposures,” explained Tim Faries, partner at Appleby, Bermuda. Events encouraged a more detailed search for alternative sources of capital in order to provide coverage for some of the really big risks, he said, risks that the ﬁnite reinsurance markets simply could not handle. Portable capital satisﬁed just such a demand, with inﬂuxes of ready capital able to enter and leave the market in response to both dislocations and overcapacity.
Watson indicated that demand for additional capital sources in the insurance sector had prompted rising interest in the alternative space. He said that the rise of collateral-backed players formed since 2008 was seen by many in the insurance space as a positive development. “As a company that buys a fair amount of reinsurance, the concern is that the bigger the event, the greater the danger of correlation,” he said. This raises concerns about the ability of reinsurers to pay, with credit risk a signiﬁcant concern following such events.
"Investors were pleased to have the choice of products offered by the alternative market, from industry loss warranties to parametic triggers and indemnity deals."
“In the collateralised space, there simply isn’t that worry. We always hear discussions about the ability versus the willingness to pay. Collateralised reinsurance takes the ability to pay question off the table.” The security afforded by such coverage is a welcome feature for cedants. For traditional reinsurers, however, it is likely to be viewed as undermining their offering. Addressing the make-up of Argo’s insurance portfolio, Watson said that the company employs a mixture of traditional reinsurance, collateral-backed coverage and ILS. Other insurers have taken a similar route, encouraging investors to enter a space in which insurers increasingly shop.
Faries picked up on this point, indicating that the rise in interest in ILS “is only the latest iteration of a theme over many years of insurers looking for alternative forms of capital”. He said that products such as ILS, sidecars and collateralised plays were seeking to marry two disparate demands: “the desire of risk managers and insurers to access capital in a cost effective and competitive way vis-à-vis traditional products, and that from institutional investors—particularly following the ﬁnancial crisis—for products that respond in a familiar way”. These new forms of capital seem to satisfy both demands and are, happily, uncorrelated from the wider ﬁnancial markets and designed to be understood by the wider investor community.
Markey did however raise a concern, that despite the desire of insurers to diversify their sources of reinsurance, cedants are increasingly retaining risk. “That is a fundamental issue for the reinsurance industry—we wag the dog occasionally, particularly on cat lines, but pretty much everywhere else we are dependent on insurers’ need for capacity,” said Markey. “And if anything, it has diminished in almost every area, which is pretty scary.” The sector is not like it was 10 years ago, he said. Insurers and reinsurers are far better capitalised than they were in the past. This has meant that insurers are better able to live without reinsurance coverage, he said. Coupled with rising levels of portable capital, matters appear to spell trouble for the position of traditional reinsurers. Many are responding by getting involved in the alternative space. Those that aren’t, may risk being left behind.
Finally, the rising cost of loss events has also played its part. As Faries outlined, “the cost of events has grown exponentially, requiring increasing need for capital”. He said that ILS-type products were satisfying much of this demand at present, but that he expected “other iterations and permutations” to emerge in the coming years as the cost of insured losses inevitably rises.
Into the supply-demand dynamic
Developments are a happy turn for the insurance sector, but traditional reinsurers aren’t entirely convinced that they are enamoured of the pop-up players. That said, Markey indicated that they probably regard developments as an evolution, rather than a threat. “Portable capital is a whole new way of managing capital in our business and it is clearly an attractive option for not only new start-ups, but also for existing reinsurers to further utilise their underwriting capabilities and manage third party capital, with fees always an attraction.” Faries concurred that it was part of an evolving marketplace, with the involvement of traditional players likely to paint the area as complementary. He added that many of the biggest reinsurers are already leaders in the alternative risk transfer ﬁeld and that “by their actions they are looking to put the message out there that these are complementary products”, he said.
Despite being seen by an increasing number of reinsurers as complementary, alternative plays do nevertheless have a competitive effect on reinsurance pricing. As Faries explained: “if you ﬂood the marketplace with additional capacity, it will inevitably affect pricing”. Some reinsurers worry about the cannibalistic implications of additional capacity driving down already soft rates. Many would argue they are right to worry. Watson—speaking from the perspective of someone who purchases insurance—said that portable capital “does not necessarily create more competition—although it has—but what it does create is more choice”.
He said that insurers appreciate the ﬂexibility now afforded them when they are considering structuring their reinsurance programme, with some of the alternatives offering the opportunity to save money. Despite the potential ramiﬁcations of portable capital on the pricing environment, Faries said that there is nonetheless a “drive among reinsurers to be involved—whether as issuers or participants in the alternative space”.
What seems inevitable is that additional capital will mute a hardening of the market. Reinsurers have been talking up the possibility of a turn for the past couple of years, but recent catastrophe events— while signiﬁcant—have proven insufﬁcient to turn the wider market. Additional capital from the markets is unlikely to help matters. Watson said that he expected it will mean the industry “won’t see another rock hard market”. Rather, products like ILS will smooth out changes in the cycle, he said. Catastrophe events create sudden supply-demand imbalances, but with the ability of this new capital to enter and leave the market so quickly, the cycle—both in terms of upward and downward development—will be less marked, he said.
Not going away any time soon
With trouble in the wider capital markets and investors looking for new ways to deploy their capital, and insurers keen to consider new ways to reinsurance their programmes, it seems likely that portable capital—despite the name—is here to stay. The question then becomes, will interest be sustained once the ﬁnancial markets pick up. Faries predicted that when the ﬁnancial markets “return to a healthier place, demand will abate somewhat, but there will always be demand for uncorrelated risks within the wider investment community”.
Watson indicated that products such as ILS are likely to remain popular despite wider economic conditions. He did however raise concerns about whether investor appetite would lessen in the face of losses that will, in time, inevitably hit such products. “There has not been a wholesale call on these bonds and until that happens we don’t know exactly how the market will react,” said Watson. However, Faries added that now that such products are increasingly tried and tested, there will be continued and growing conﬁdence in their potential. Watson likewise argued that once such products become securitised and investors feel comfortable with them, interest will continue to grow.
Watson said he expected portable capital’s share of the catastrophe market to continue to increase and by as much as 10 percent in the next few years. Markey was similarly conﬁdent about its potential, arguing that it will continue to expand and, in all likelihood, faster than the traditional marketplace. Addressing the potential for growth in the ILS and collateralised space, he said that US, European and Japanese risks dominate the offering, but that there is potential for growth in other emerging geographies. “What may surprise some is the potential scale of risk-taking and capital that is in this area,” said Markey.
The growing inﬂuence of portable capital in the catastrophe space may yet change the make-up of the landscape. As Markey indicated, present catastrophe business is a mix of traditional and more alternative forms of capital, but it remains to be seen whether alternative forms will emerge as the dominant play. As Markey explained “a lot of investors in the traditional space are pretty illiquid at present and that is something of a nuisance. The old model of creating a new company, running through three to ﬁve years and then IPOing—while certainly not impossible—is clearly not the ﬂavour of the current marketplace”.
Alternative plays, on the other hand, evidently are, as they continue to gain traction and market share. What seems likely is that reinsurance products will necessarily have to attend to the appetites of insurers and investors, and as these grow more sophisticated and the types of investor more diverse, we can expect more demand for easily deployable and understood portable capital.