Will capital markets continue investing in reinsurance?

24 October 2016

Could the inflow of alternative capital dry up when the market turns, or will it spawn even more alternative risk solutions?

The more people caution that the end of the insurance linked securities (ILS) boom is just around the corner – or whenever the next catastrophe hits the market – the more resilient it becomes.

The past decade has seen the ILS market mature from a catastrophe (cat) bond market worth $17bn (2006) into a more diverse range of investment vehicles, with over $70bn invested at the end of 2015.

Fears that major claims would shake investor confidence have proved unfounded. Recent years have seen the market withstand the shock of Hurricane Katrina, Lehmann Brothers collapsing, the 2011 windstorm season and Superstorm Sandy in 2012, among others.

Diversifying the books

A key part of the attraction is the opportunity to escape from the straightjacket of correlated risk, says Michael Popkin, Managing Director and Co-Head of Insurance-Linked Securities at JLT Capital Markets.

“Pension funds, endowments and large managers of capital want to invest in uncorrelated asset classes. Catastrophe risks are very much uncorrelated with the broader economic risks most portfolio managers face, whereas there is such a correlation with crude oil prices, which have a direct impact on equity prices and foreign exchange holdings,” says Popkin.

“Mother nature does not care about the size of the mortgage on the house it is about to destroy, nor does it care whether that mortgage happens to be securitised into a bond format,” continues Rick Miller, Managing Director and Co-Head of Insurance-Linked Securities at JLT Capital Markets”.

ILS also enables (re)insurers to shift peak risks from their books and into the capital markets. There the depth and liquidity of capital enables investors to bear risk more efficiently, at the same time helping them avoid the trap of carrying too much correlated risk.

No retreat

The consistent growth in ILS must come to an end, say some doubters. However, capital is unlikely to exit as quickly as it has entered, says Popkin.

“Why would capital retreat? There is a lot of capital sitting on the sidelines that has already invested into these funds, which can move very quickly to increase their investments,” says Popkin.  

“There will be peaks and valleys but these will become more muted and the durations will be shorter, further enhancing its appeal. If some capital exits then reinsurance rates will harden and the ILS market will become even more attractive to pension funds.”

The attraction to investors will remain strong and so will the attraction to cedants, says Rick Miller. “They can take a catastrophe risk and turn it into a catastrophe bond or collateralised reinsurance to transfer that risk to the capital markets.

“Historically, the costs of doing that were quite high but our role is to access those growing capital markets in an efficient and cost-effective manner.”

Growing attraction

To do this JLT Capital Markets has created Market Re, a proprietary platform for transferring a wide range of catastrophe risks to the capital markets. With more cedants looking hard at how much catastrophe risk they have on their books, the capital market option is becoming more attractive to them, says Miller.

“Clients are also attracted by the faster payouts and more transparent payments from the capital markets. The potential to have liquidity is also an important part of the catastrophe bond market.”

Another fear among some sceptics was that the capital markets wouldn’t be sensitive to the need to pay claims efficiently. This is unfounded, says Popkin: “The bonds have a history of paying out. Look at what happened after Hurricane Patricia in Mexico, in October 2015.

“The bonds paid out quickly because they had a simple, transparent threshold. This meant the client received money to reinvest in the local economy and help recovery very quickly.”

What next?

With ten years’ consistent growth and a solid track record behind them, many clients are starting to realise the potential for the capital markets to diversify even further, says Popkin.

“We are working with specialty markets to see what other opportunities there are for transferring elemental cat risks and weather risks. Also, business interruption and contingent business interruption are well suited to the capital markets.

“Businesses retain weather risk – for example, too much rain or snow or it being too hot or cold – that affects both revenues and costs. They should consider shifting these risks to ILS investors,” says Popkin.

This growing diversity has accelerated since 2012, which is when the collateralised risks first overtook cat bonds to become the largest element in the ILS mix.

Let’s converge

As the flow of capacity from third-party investors has become a permanent feature of the global (re)insurance industry, more primary insurers and traditional reinsurers have sought to partner with ILS and incorporate it into their business mix.

This has brought the topic of convergence between the traditional risk transfer markets and the capital markets to the fore.

“It isn’t a question of when or if convergence will happening. Convergence has already happened,” says Popkin.

“Many reinsurers now have asset management platforms and it is increasingly difficult to tell what is a traditional reinsurer and what is a capital market fund. Capital markets are here to stay.”

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For more information contact Michael Popkin, Managing Director and Co-Head of Insurance-Linked Securities at JLT Capital Markets. on +1 212 309 3475 or email michael.popkin@jltre.com.