Named as one of the top ten disruptive innovations of 2014 the securitization of insurance risk has transformed the capital structure of the reinsurance industry, with insurance-linked securities now making up 15% of the total global capital dedicated to reinsurance.
From the first small catastrophe bonds issued in the mid-1990s to the now more than $65bn of investor capital entering the reinsurance market via sidecars, industry loss warranties (ILWs) and collateralized reinsurance, insurance-linked securities (ILS) are now a mainstream component of the reinsurance industry.
Re/insurance risk’s lack of correlation with the financial markets makes it an attractive hedge. And the continued low interest rate environment has stimulated the financial markets to seek yield outside of traditional credit-based instruments.
Investors continue to grow in confidence and broaden their horizons as the ease of executing such transactions has improved. As a result, the use of collateralized reinsurance has been a major growth area (see chart above). But so too the catastrophe bond market continues to grow – 2014 was a record year for catastrophe bond issuance and looking at the 2015 half year numbers, it will not come as a surprise if 2015 turns out to be another record breaking year for non-life issuance, despite investor assets growing at a lower rate.
The rise of insurance-linked securities is set to continue, and will continue to contribute to the transformation of the reinsurance industry.
Indeed, to note, the current changes within the sector have not solely been driven by the “alternative“ investment community. Much of the disruption has come from within the industry itself, with reinsurance placements shrinking as carrier buying behaviour has evolved, moving towards the centralization of reinsurance purchasing and the increasing retention of risk as carriers seek to improve margins in the low investment environment.
The increasing competition from ILS is placing further pressure on the traditional reinsurers, but ultimately, ILS is providing more breadth and diversity to an already changing market. At the same time, ILS has created retrocessional capacity for those same reinsurers so in some case the net effect is a positive for them.
A Long-term Commitment?
The main contention surrounding ILS has been to question whether the “new” capital will pay out, and if it is here to stay after a substantial loss event, noting that the majority of markets and catastrophe bonds are as yet untested. However, some of these markets do have a proven track record, with both the collateralized re and cat bonds paying out substantial amounts over time. The first significant loss in the cat bond market was caused a decade ago by Hurricane Katrina.
Further, it is important to differentiate between investors. Some, for example, created in the early 2000’s have gained a similar stature to the traditional reinsurers in terms of their claims paying activity, their ability to regenerate and their ability to provide more capital after a loss.
The investor profile today is a lot more committed as a whole than 15 years ago when a portion of the participating investors (e.g., multi-strategy hedge funds) had more of a short term view. Pension funds are now backing a substantial amount on a worldwide basis. They have moved in slowly, and have become more comfortable and supportive of transactions that are closer to the risk and more likely to trigger. Ultimately, relative to the trillions of investment capital these institutions hold, any payment would have a modest impact on their overall portfolio.
Also, unlike multi-asset hedge funds, pension money is less likely to be affected by transitory relative value shifts among asset classes. Stated differently, if suddenly high yield or commodity returns become much more attractive on a risk-adjusted basis, the pension money will not move away from ILS in a material way until it becomes apparent that the risk-return shift is semi-permanent.
So the reliability of the current capital is what differentiates the “short-termism” claim from the past; with the array of specialist investors now in the market, those that say these investors do not have skin in the game are wrong.
We will not know the outcome for certain until the next game-changing event hits, but we do know that investors are realistic and have an understanding of what the impact of a major event or series of major storm events may have, such as we saw in 2005, or a large earthquake in Los Angeles, for example. They understand the risk models may not be 100 percent accurate and therefore larger and currently unmodeled losses could occur, such as a major tsunami hitting the US coastline, that could wipe out the reinsurers as well as investor money – the net impact here is far less clear. But that is the case for the entire industry.
Indeed, with the arrival and emergence of ILS capital in size, some question the ability of traditional reinsurers to regenerate capital following large events, as in the past. With the reinsurance cycle muted, the other argument is that equity investors may question the merit of reinvesting.
As such, having both traditional reinsurers as well as ILS bodes well by providing more legs to the stool in case one falls away. The net result is a more stable, resilient and affordable insurance market through all market conditions.
Taking on New Perils
The vast majority of the ILS market is invested in US property catastrophe reinsurance products, where such peak perils are well-modeled and economically viable (see graph below).
Similarly well-modeled risks such as European windstorm, Japanese earthquake, and typhoon have long had a presence in the market. But more and more, the underlying economics in other areas are improving, as well as the models, and there are real prospects for broadening the scope of products available.
Australian risk is being included in transactions now, as is Canadian risk, and we are seeing deals emerging in Turkey and potential in the wider Asia-Pacific region outside of Japan. China is also an area where we see opportunities in the nearer-term.
There is a strong appetite for investment in diversifying perils. A recent example is the Azzurro Re I cat bond for UnipolSai, the industry’s first catastrophe bond to cover Italian earthquake and ensuing perils as primary risk, issued earlier this year.
Cyber is another example of a new area for growth. The lack of holistic models, which are well-established for property catastrophe, has hindered the industry’s ability to offer wider protection – without clarity around the potential total exposure faced, insurers have ultimately been constrained in underwriting this risk class due to the uncertainty of the potential financial impact. The modeling deficit has also hindered non-proportional participation from reinsurers and ILS investors.
But the development of more refined models (going beyond the existing actuarial tools) make it more likely that cyber risk, and casualty risk in general, will eventually find a home with investors. As with other perils, (e.g., flood and terror), with improving modeling, participation will start with sidecars (on a proportional basis) and multiperil cat bonds and then potentially will move to standalone single peril cat bonds.
One important distinction between any casualty risk and natural catastrophe is that the former is not always short tail in terms of loss development. As such, understanding the shape of the loss development tail and managing it in the risk transfer structure becomes very important. Risk transfer of medium tail rather than short tail risks is inherently more challenging for capital markets capacity. But there is promise in this market.
Sidecars are a particularly useful tool to employ in the emerging risk space, and there has been a trend towards more long-term and strategic use of such vehicles. There has been significant growth in the use of side cars and it is likely we will continue to see a considerable uptick in their usage.
In sum, the insurance-linked securities market is growing, healthy, and of keen interest to institutional investors, insurers and reinsurers, and increasingly to corporates and governments as well.
- Willis: ILS Glossary
- ILS market update: WCMA ILS Quarterly Report: Q2 2015
- WillisWire: What Is Basis Risk and Why Does It Matter?
- WillisWire: Corporate Cat Bonds: The Next Frontier?
*Investor assets growing at a lower rate: Over the last few years we have seen 15-20% growth in ILS products. We are now seeing 5% growth. However, investor capital continues to grow. Another trend we are seeing is that investors are using leverage, enabling them to write higher limits beyond the amount of capital they hold, which is generating a not insignificant amount of growth.