The great ILS debate: part 1—those in favour

A number of factors including rising rates and poor investment returns in more traditional markets, have meant an influx of new capital into the reinsurance industry in recent years. This is nothing new to an industry famous for its cyclical nature with many of its now most established players formed during the post-catastrophe boom years when, historically, rates would increase exponentially.

This time has been different, however. Instead of capital entering the market through newly formed reinsurers mainly based in Bermuda, this time around it has been put to work through less traditional channels. A wave of sidecars, index-linked warranties and fully fledged catastrophe bonds has instead emerged to opportunistically participate in programmes—and their emergence has split the industry into those that embrace this as an opportunity and those that view it as a threat.

A historical context

Before getting into the arguments on each side of this debate, however, it is worth putting the emergence of this alternative form of capacity into context. A recent report by PwC called Unlocking the potential of ILS points out that less than 20 years after the first insurance-linked securitisation (ILS) was launched, this sector alone now accounts for 14 percent of global catastrophe reinsurance capacity.

“Given the 700 years that the reinsurance market has taken to develop, the speed at which ILS has evolved within the market is remarkable. However, it still has a considerable way to go in order to fulfil its true potential,” says the PwC report.

The report notes several challenges the sector still faces. Many investors remain wary of ILS, viewing it as opaque and shrouded in uncertainty, but it also notes that this is also the way that many investors view traditional reinsurance.

To overcome some of the challenges ahead for ILS, the report says the complexity of deals must be reduced. “This will enable investors to understand better the risks that they are taking, as well as the potential rewards that they could receive. Once this is achieved, critical mass could be achieved within the ILS market, as it moves out of its niche and into the mainstream.”

It also suggests that more innovation will be necessary. The growth of ILS has been driven by innovation, with new structures created every year to match the demands of the market—and this process must continue, the report says, while also offering the stability of capacity levels and pricing often lacking in the traditional reinsurance sector after big events.

“While ILS has developed at a fast rate, there is still much more improvement to come,” the report says. “Technological advancements in risk analysis will also enable ILS sponsors to further improve pricing techniques and to fine-tune structure to match investor appetite. It will also enable those practising in ILS to achieve greater transparency, and therefore attract a broader base of investors. Advancements in risk evaluation could also enable the creation of more responsive ILS solutions.”

The growth of ILS this year, in terms of the issuance of pure catastrophe bonds, is quantified in Evolving strength, a report by Aon Benfield. It notes that in the first half of 2012 there was an increase in both sponsor and investor demand in ILS. Annual issuance volume reached $6.4 billion in the first six months of 2012, an increase of more than $2 billion over the same period in 2011.

“This performance marks a period of growth for the ILS market. Over the three prior years, decreases had been witnessed in both total outstanding volume due to the higher notional amount of catastrophe bonds reaching maturity, and lower issuance volume following the global financial crisis,” the report says.

Aon Benfield says that some of the improvements PwC calls for are already well underway. Transparency has increased in recent transactions, with investors privy to more detailed exposure and modelling data. Sponsors of indemnity issuances in particular have provided more detailed exposure information, such as county level data where state level data was previously standard. This increase in transparency has enabled investors to analyse new offerings more thoroughly.

Meanwhile, enhanced modelling information has also become more standard. For example, investors have now been provided with event loss tables and files for users of proprietary models more often.

The Aon Benfield report also notes that recent losses have confirmed the robustness of this sector. Investors’ appetite has not waned as a result. It says several loss transactions issued in the fourth quarter of 2011 limited investors’ appetite for that level of risk in the following quarter.

Investors remained keen, however, to put their capital to work, as many continued to receive inflows from their own investors. As the second quarter of 2012 came to a close, a slower primary issuance market created a very active secondary market as investors looked to deploy capital.

The report concludes: “Conditions remain positive for catastrophe bond issuance for the remainder of the 2012 calendar year. There is strong investor demand for bonds, and both repeat and new sponsors are expected to engage with the ILS market for diversification and to complement overall reinsurance purchases.”

This is clearly good news for cedants, and the investors in such instruments are clearly happy with the growth of this market and the returns they are getting. But catastrophe bonds are just the tip of the iceberg in terms of the many ways new capital has been entering the market—and the dynamic has split the industry.

Dividing opinion

In one camp, there are many reinsurers which are actively involved in the growth of this market. Some make their balance sheets available to front transactions for new capital, others lend investors their expertise in establishing books of risk.

Stephen Young, executive vice president, chief underwriting officer and head of global catastrophe reinsurance at Endurance, told this magazine in Monte Carlo in September that traditional reinsurers should view alternative sources of capital as complementary to their own offerings, while also making use of it themselves.

“There is strong investor demand for bonds, and both repeat and new sponsors are expected to engage with the ILS market for diversification and to complement overall reinsurance purchases.”

The use of collateralised vehicles, for example, will evolve over time to complement traditional capacity. But he also noted that the new capacity is affecting only very specific parts of the market: it has been very US focused and at either the very low ends of high rates on line—so either Florida or retro—or at the top ends of programmes, with much higher attachment points and lower expected losses, through a cat bond structure. “Traditional reinsurance product essentially fills in everywhere else,” he said.

Other proponents of the use of this form of capacity—generally speaking—are the brokers. In Monte Carlo Guy Carpenter gave strong arguments for its use, arguing that the line between what constitutes traditional and non-traditional capacity is now redundant.

The way in which cedants use the capital markets and traditional reinsurance capacity to hedge their risks has converged to the point that both are almost equal in cost and buyers can pick and mix products that best suit their needs, argued David Priebe, vice-chairman of Guy Carpenter, at a press conference during the Rendez-vous.

“The reinsurance industry has come of age and the old distinctions between traditional and non-traditional are redundant,” he said. “The price difference has narrowed, basis risk is better understood and transactions are smoother, quicker and cheaper to execute.

“Buyers with large catastrophe exposures now view a whole range of products ranging from cat bonds and ILS to sidecars and fully collateralised retro programmes as a core part of this risk strategy. They are no longer an ad hoc add-on used only in certain circumstances and for certain risks.”

Guy Carpenter Securities estimates that some $34 billion of propertycatastrophe capacity now comes from non traditional sources, a growing percentage of the $240 billion capacity from all sources globally, said Priebe. They deliver a number of benefits to buyers in addition to the extra capacity they provide, including greater diversity in terms of counterparty risk.

Specifically in terms of catastrophe bonds, he also noted that in the first half of the year a record 15 deals were launched, representing $3.4 billion of risk principal. Including these new deals, the total capacity of bonds outstanding in the market is now some $13 billion, not far off the market’s 2007 peak of $14 billion, just after Hurricane Katrina. By the end of 2012, GC Securities estimates the market will top $15 billion.

Priebe also argued that the growth of this market makes the role of the broker more important than ever. “Only the broker has the ability to design a full range of solutions for clients incorporating a full range of capital suppliers,” he said. “The converged markets are the new domain of the broker more than ever—and we are excited about this.”

One group that tends to agree with Guy Carpenter on the topic of convergence is the bankers who specialise in structuring these deals. Shiv Kumar, managing director of structured finance in the investment banking division of Goldman Sachs in New York, said that he believes the use of so-called traditional and non-traditional sources of capacity by cedants has not completely converged just yet—but he thinks such a scenario is not far away.

Buyers will eventually think purely in terms of funded and unfunded capacity, regardless of whether it ultimately comes from the capital markets or traditional reinsurers, he said.

Many buyers already access different pools of capacity depending on what best suits their needs and risk profile, and the boundaries between the two markets are becoming ever more blurred. “A lot of the big reinsurers have been offering fully collateralised products through things like sidecars for some time now while also getting involved in cat bonds,” Kumar said.

“They also manage ILS funds and have started using cash from third parties to offer products. Meanwhile, companies such as Nephila Capital on Bermuda and Credit Suisse offer collateralised reinsurance in a more traditional format.”

Kumar does not see the rise of non-traditional capital as a threat to traditional reinsurers, saying: “They have been adapting their models for some for some time now; it is an evolution of the traditional reinsurance model, and it is not harmful to traditional reinsurers.”

But he believes a few things still need to happen for the two markets to converge fully. “Another major catastrophe would probably cause that because I think we would see a lot of sidecar capacity in particular enter the market,” he says. “Plus, the existing trends simply need to continue.”

The industry will eventually see sources of capacity in its simplest form: funded and unfunded or, possibly, long-term and short-term risk. “You have investors that will come in for the short term and deploy capital with specific expectations in terms of returns, and others who are committed for the long term. Those are the two simplest ways of viewing capacity. Beyond that, buyers may not worry who provides it,” Kumar says.

One of the criticisms of this non-traditional type of capital is that it is opportunistic and may not stick around when investment returns in other sectors improve or times get tougher—either through a softening of rates or sudden high levels of claims—in the catastrophe risk sector.

But many believe this form of capital is here to stay. Jamie Veghte, chief executive of reinsurance at XL, said that not only are they here to stay, they will become increasingly important to the market, especially after big catastrophe losses. Traditional reinsurers will have to adjust to this new dynamic or be left behind.

“I am a believer that intelligent capital will enter the market following a major event and remain, rather than simply disappear,” Veghte says. “It may not be permanent in nature, but such forms are certainly here to stay.

“The longevity of that security in the aftermath of a major event sometimes comes into question, but I think you are going to see more activity in the sidecar and ILS space post-event, rather than less. Where there will likely be less development is among the traditional equity-raising classes of 2001 or 2005.”

XL has been heavily involved in the alternative capital space since its inception. It launched its first sidecar, Cyrus Re, back in 2005 and remains involved. And, Veghte says, the company is seeking new partners.

Potential investors view XL’s 20-year track record as an attractive proposition. By working with XL, they can piggyback on its expertise, market relationships and strong track record, he says. With yields in the wider investment markets still poor, investors are keen to explore the potential of reinsurance.

Veghte adds that a relationship of this nature could, in theory, be applied on a much wider basis. This would mean a fundamental change in the industry, but he sees such a model as realistic.

“If, in the end, capacity became virtually all third party capital being managed by companies such as XL, the industry would be fine, because those embedded assets could still be utilised in order to deploy that capital,” Veghte says.

This issue has divided opinion in this industry, however. There are many who see it as a threat to traditional reinsurers and believe the sector is already feeling the consequences. In the next edition of Intelligent Insurer, we hear from those players nervous about this new development in their industry.