The abundance of capacity in the global reinsurance sector from both traditional and alternative sources suggests it might take a number of large events in succession to materially turn pricing, which J.P. Morgan says would be a test for the insurance-linked securities (ILS) space.
The lack of large losses witnessed in the reinsurance industry in recent times coupled with the oversupply of capacity are the two main drivers of falling rates in the industry, says J.P. Morgan.
As a result, the volume of available reinsurance capital has reached a record high nearing $600 billion, while alternative reinsurance capital, or ILS increased its share of the total market to $81 billion as of the end of 2016, according to Aon Benfield analysis.
In order for rates across the global reinsurance industry to stop falling and for the softening market to start to turn, J.P Morgan analysts believe it might require a series of large loss events in succession, or an event so large that it goes beyond the scope of existing modelling tools, to turn pricing.
For the growing base of ILS capacity, which is increasingly deepening its participation in a wider scope of insurance and reinsurance markets, a series of large events "would be a major test" for the sector, says J.P. Morgan.
In recent times ILS has been looking to get closer to the original source of risk, jumping down the value chain to increase efficiency and profits while limiting competition. As the market expands into new peril regions via private ILS, collateralised reinsurance agreements, catastrophe bonds, sidecars, and so on, its exposure to an aggregation of attritional losses is rising.
Catastrophe activity so far in 2017, especially in the U.S., has been active, with $5.7 billion of losses being recorded in the first-quarter of the year alone, and with adverse conditions and intense convective weather continuing through April and May that is expected to drive further insurance and reinsurance industry losses.
As a result, Artemis has discussed how aggregate ILS arrangements, particularly U.S. exposed, are at a greater risk of becoming riskier as deductibles erode, essentially increasing the risk of losses later in the year.
While the frequency of events and subsequent losses so far in 2017 aren't as high as those J.P. Morgan suggests could be needed to turn pricing, ILS fund managers will be keeping an eye on the aggregation of events and with the U.S. tropical storm and hurricane season still to come J.P. Morgan's warning is a sensible one.
It's been discussed numerous times that the ILS market remains untested against a substantial loss or significant removal of capacity from the reinsurance sector, but as the market expands and losses start to aggregate it might not be too long before its permanence and performance in the face of truly market turning event is put to the test.
Of course the same aggregation of events would severely test the traditional reinsurance market as well. Losses would spread through the market and risk controls would be tested.
At that point in time the diversity and portfolio management, as well as risk selection and underwriting skills of ILS fund managers will become clear, providing the investor base with greater transparency into how much volatility each manager holds and how exposed they are to risk aggregation.
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