An interesting debate took place at a seminar held in Bermuda last week, as senior executives from traditional insurance, reinsurance and insurance-linked securities (ILS) firms discussed the future of third-party capital in reinsurance.
The event, an insurance and reinsurance seminar held by the Bermuda Monetary Authority, saw executives agreeing that alternative capital was likely to be a long-term feature of the reinsurance market, but some warned that there is a need to ensure alignment of the understanding of the risks with the ultimate providers of the capital.
Some warned of the temptation to separate the risk from the capital, which is an interesting opinion when those managing the bulk of the third-party or ILS capital in this sector would see their jobs as matching risk and capital, so in essence bringing the two closer together than perhaps they have ever been in the reinsurance market.
It's worth taking a step back to consider why the capital markets became directly involved in the reinsurance market in the first place. The key driver for transferring insurance risks to the capital markets back in the mid-1990s was an understanding that traditional insurance and reinsurance capacity alone was not sufficient to absorb the very largest peak catastrophe or life insurance risks.
So the insurance-linked securities (ILS) market began to develop, primarily with the use of catastrophe swaps, cat bonds and other financial market instruments, which also brought an element of efficiency into the risk transfer and allowed the risk to be directly transferred to those providing the capital, in a form that met with institutional investors mandates and appetite for investment structures.
Since those days, of course, the ILS market has developed more rapidly in recent years, with the majority of ILS capital now used to collateralise reinsurance contracts. That development came to the fore as a way to meet the needs of the customer, the ultimate insured who did not want to go through the complicated process of issuing a catastrophe bond, or where the underlying re/insurance contract was not large enough to warrant securitisation.
And we find ourselves now approaching 2015, with a $60 billion-plus pool of third-party or alternative capital effectively acting as reinsurance capacity, collateralizing reinsurance contracts in a variety of structures and forms.
So a key driver for the development of this market was for insurers and reinsurers to be able to access the deepest pool of capital available to them for the transfer of peak risks. The capital markets and institutional investors are clearly the largest available pool of capital in the world today. With an opportunity to provide these investors with a new asset class that provides qualities that make it an appealing addition to a diversified portfolio, the ILS market has taken on the mantle of matching risk to the appetite of this capital.
At the BMA event, senior executives of traditional reinsurers discussed the potential for ILS and alternative capital to be abused, or to develop into something that is negative for the reinsurance market.
One participant at the event, Mike McGavick, CEO of Bermuda-headquartered global insurance and reinsurance firm XL Group (NYSE:XL), commented:
“I think the likelihood of it (alternative capital) evolving into something less stable or abusive is real and this is the thing we really all ought to be thinking about because that drives to the heart of trust in the system and we don’t need distrust in our system.”
“There’s opportunity for there to be new clashes in exposure that are unrecognized and when they come due are un-payable. And in essence this is the story of the real estate crisis and that is the risk here because the risk is being removed from those that took the risk. The advantage of the integrated model is you’re betting with your money. That changes how you feel about it,” he continued.
John Nelson, Chairman of the Lloyd’s of London re/insurance market, said:
“It’s going to be a continuous challenge, that as the alternative capital market develops, the temptation to detach the risk from the capital becomes ever greater and there will be kinds of securities where the returns look really alluring but if we do that we will destabilize the whole thing exactly as happened in sub-prime mortgages.”
These warnings are apt, there is a real need to ensure that the alignment of interest is strong between those managing third-party capital and the investors, as well as for investors themselves to fully appreciate the role they play in assuming and collateralizing insurance and reinsurance risks.
But where is the separation of risk and capital perhaps most evident in the reinsurance market? It’s really within the traditional business model. Here, shareholders provide the capital and have multiple, organizational layers of separation between themselves (their capital) and the risk.
We would venture that the connection of capital to risk is actually stronger in the more efficient ILS model, in some cases much stronger as some of the biggest investors allocate capital directly into reinsurance contracts and catastrophe bonds.
The speakers may also have been referring to the link between capital, the return it seeks and the actual level of risk being assumed as well. In fact, for us, that is a much more pertinent question, is the capital truly being deployed at levels that are commensurate with the risks assumed?
One issue that is often looked over when discussing pricing, whether it has declined below technical levels and whether capital is being allocated to risks at levels that are not commensurate with the understanding of that risk, is the fact that it is really not in the interests of managers of third-party capital to deploy that capital too cheaply.
If your business is in making an income from managing investors' money, using your expertise and skill to deploy it into the most attractive opportunities, and you’re paid based on performance and how much capital you manage, there is really no sense in deploying it too cheaply.
Hence the majority of ILS managers return capital to investors occasionally and advise investors to step back from the market if it no longer meets their return requirements. This has happened much more than you might think, especially over the last year.
So it would seem to us that there is little incentive to drive pricing down below technical levels for ILS managers, at least those that we have relationships with. Similarly there is little incentive for reinsurers to drive the price down so low that they aren’t making a profit from it.
However, traditional reinsurers are said to have been writing business at levels approaching cost of capital and using prior year reserve releases to boost their returns. In fact, some lines of business seem to have been underwritten at combined ratios of above 100 for what seems an eternity, typically as the diversification benefits allow that.
Do insurers and reinsurers shareholders really understand this? Is the connection between risk and capital in the traditional reinsurance business model really that tight anyway?
So perhaps the debate here is really (or should be) all about the cost-of-capital, rather than how tight the links is between capital and risk?
ILS capital can be deployed into some classes of peak catastrophe risk at levels that may appear too cheap to some reinsurers. Similarly, some reinsurers can underwrite some classes of business at levels that appear unprofitable due to the diversification effects or the benefit of the float which they can then invest over a longer-tail to make up the return.
It seems to us, with our simplistic view of this world, that different types of capital have different motivations, different return requirements and different risk appetites. Add to that the efficiencies of a leaner business model, of capital market structures, versus large global insurance and reinsurance operations, and it becomes very hard to really compare these business models.
Back to the event and the premise that ILS was developed for a reason, to provide access to the deepest available pool of capital for the transfer of peak risks in an efficient manner.
Co-founder and Principal of Nephila Capital Frank Majors, also speaking at the event, acknowledged that there are risks in every sector and business model: “This development of alternative capital does have the possibility for concern, or abuse, or misuse, or being taken too far in the future.”
Majors explained what he sees as a key positive of the entry of alternative capital into reinsurance:
“Right now I would just like to make the point that the effect of the alternative capital is to actually de-lever the industry significantly. So it’s very different right now, in this stage of development, very different from the mortgage securitization which was a process of adding leverage. What it really is, is taking a risk off of levered balance sheets onto unlevered balance sheets.”
This is in essence the same driver that saw ILS developed, the belief that the insurance and reinsurance industry alone could not bear the burden for peak risks. Another factor in this is the history of spirals in insurance and reinsurance, where the risks are insured, reinsured and retrocessionally reinsured among the same group of balance-sheets. Getting risk off balance-sheet and away from the leveraged sector is surely a positive for the industry and goes a long way to explaining why many insurers and reinsurers embrace ILS and the capital markets as a source of risk transfer.
Majors went on to explain that he did not think of alternative capital as “a new group of people showing up at the party,” but rather as a tool to provide access to additional pools of capital. “If you have access to deeper pools of capital that should add stability, unless it’s abused in some way,” Mr. Majors said.
Here we are in agreement. Stability is something that should be provided as a result of the entry of alternative capital into reinsurance. Stability in terms of pricing and the cycle is one thing, removing the huge price spikes of the past after major catastrophe events hit. Stability in terms of reinsurance capital being available is another, if a really major event occurred, wiping out a number of insurers and reinsurers, alternative capital would likely still be there to support the risk transfer requirements of cedents.
Another interesting participant at the BMA event was Andrew Bailey, Deputy Governor of the Bank of England and CEO of the UK’s Prudential Regulation Authority, who gave his view on the issue being discussed. Bailey said that it is not part of a regulator’s role to prevent the entry of capital into an industry.
“The fact that there is capital coming into the industry is not something that we should react adversely to,” Bailey explained. “One of the things we’re concerned about is underwriting standards and we’re obviously also concerned about the robustness of the management of risk and the spreading of risk, so those should be the points of our focus to ensure that, given we have new capital coming in, that the process maintains the prudential standards we expect.”
That is a pragmatic approach to regulation that (we’d assume) nobody would object to. ILS managers and those stewarding third-party capital who we speak to are extremely keen to ensure underwriting standards are maintained. Any who aren’t shouldn’t be in the industry.
Brian Duperreault, CEO of Hamilton Insurance Group and also speaking at the event, commented on how alternative capital has changed reinsurance, saying: “I just think the world of insurance today is such that you don’t have pure reinsurers anymore.”
“The alternative capital and the ILS market in particular, have gravitated to the big bang cat,” Duperreault continued. “The reasons for that, rates on line match nicely with interest rates, non-correlation, and etcetera. If it breaks out of that, and one would assume over time that happens, it gets into a messier area of the insurance business where it’s not as simple.”
This is one of the valid concerns, that ILS attempts to move into new lines of business too quickly, where it is much harder to really understand the risks being understood and so matching them with the right capital, at the right price and in the right structure becomes much more difficult.
McGavick noted a positive development, that he felt that underwriters have recently become more involved in the process of matching risk to capital in the alternative capital space. “That is a changing dynamic which is very positive because it reminds us that underwriting is still at the center of the art,” he commented.
This is certainly a sign of the ILS market growing up, finding its feet and realizing that if it is going to steward billions of dollars of investors capital into risks, it needs to ensure it has the correct skillsets and manpower to be able to accurately model, assess and underwrite these risks.
On the cycle and recent reinsurance market softening McGavick commented: “One thing about insurance, I can guarantee every time there is more capital than there is available risk, we will skeeter off into inadequate pricing. It will happen every time.”
An accurate statement, however it is misleading to suggest that this only happens due to ILS capital, as this has happened in the reinsurance market long before ILS or third-party capital existed. Now, the capital is more mobile, quicker to move in, more efficient, the structures are in place and understood and so the impacts more acutely felt by some incumbents, we would suggest.
“It’s a combination of human optimism and the fact that we are the only industry we know of where we don’t know the cost of goods sold. We just don’t know and we will screw up, go over cliffs and need to recover,” McGavick continued.
This is a really important point to reflect on. Insurance, reinsurance and alternative capital or ILS do not know the true cost of the product they sell. Best efforts are always made to price risk commensurate with the view of risk, the appetite for risk, the cost-of-capital, the margin required to be made, and many other factors.
As McGavick says, mistakes in terms of pricing can and will be made again. However we’d point out that these mistakes can and will be made by both traditional players and ILS specialists or those managing third-party capital and are often the result of a changed view or understanding of the risk emerging.
The question is, when something like this happens, how close is your capital to the risk and have you prepared the providers of that capital for the fact that they can lose money, as well as make it, from an allocation to this asset class?
Those who haven’t aligned their capital and educated it on the risks inherent in insurance and reinsurance could be in for a shock. However, that could be traditional reinsurers who could bleed shareholders or ILS players who could lose investors, both are equally at risk of capital flight after an event, in our opinion.
But back to the title of this article, the deep pool of capital that the insurance and reinsurance market now has access to, thanks to the development and evolution of the insurance-linked securities (ILS), catastrophe bond and collateralized reinsurance space and insurance and catastrophe risk becoming an asset class.
For traditional players in the insurance and reinsurance space, this really needs to be seen as a positive. It’s a trend that isn’t going away and these players now have the opportunity to leverage this deep pool of capital for growth and stability for the benefit of their ultimate customers, the people and businesses seeking access to risk capital to help them to protect themselves and recover from the most impactful events.
From our perspective, the key takeaway from this interesting debate held at the BMA event in Bermuda could be summarized as: The ILS market and those who seek to manage and be custodians of this capital have gained access to something very important, a deep pool of diversified risk transfer capacity with the ability to assume peak risks. As a result, they have the responsibility to ensure that this access is not abused and that this trend does not result in an erosion of the trust that has been built in the reinsurance and risk transfer system.
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