The great ILS debate: part 2—those against

Hardening rates and poor investment returns in more traditional markets have meant an influx of alternative forms of capital into the reinsurance industry in recent years. This is nothing new in an industry notorious for its pricing cycles but this time the capital has entered the market in a very different way.

Instead of coming in via new reinsurers, it has been put to work through a myriad of alternative investment vehicles ranging from the well-known and understood insurance linked securities (ILS) or cat bonds to a mixture of sidecars, industry loss warranties and other instruments.

In the last issue of Intelligent Insurer, we spoke to a number of companies that argue that this is healthy for the market. They believe it represents a natural evolution for reinsurers to participate in such schemes and that it means an attractive range of risk transfer options for cedants.

But the emergence of this capital has not been welcomed by all in the reinsurance industry. There is also a school of thinking that sees such capacity as harmful to the industry. The main criticism is that it has prevented reinsurers from enjoying a true hardening of rates—that it has taken the peak off pricing in the market.

Shaving the peaks

Stephen Young, executive vice president, chief underwriting officer and head of global catastrophe reinsurance at Endurance, is a believer that this form of capital is healthy for the industry and is here to stay. In fact, Endurance is actively involved in facilitating its use and advising investors.

But he also admits that it has cut the extent of the pricing peaks in terms of rates—something reinsurers used to rely on to replenish their reserves in the aftermath of big losses. “If we had $100 billion of loss in other years, without this capital coming in we might have seen higher rate increases,” he says.

Andreas Molck-Ude, the chief executive of New Re, agrees. He believes the new capital has had a tangible effect on rates and goes as far as arguing it could even lead to prices being depressed—quite a statement when the scale of the losses the industry endured in 2011 is considered.

“An effect of the strong growth of the collateralised reinsurance market, with huge amounts of capital flowing in, has led to a dampening of the prices,” he says.

“Otherwise I would have expected prices to move up more than they did. I think that the influx of capital has more or less flattened the prices and if it continues it will lead to slight reductions in them.”

Molck-Ude agrees with those who claim this form of capital is here to stay—but perhaps not to the extent some believe. “It is here to stay, but not in the magnitude that we see at the moment. I think that the magnitude is partly caused by the fact that the returns achievable in other investment segments are very small.

“That means money is being put into this area because it looks attractive by comparison and, if and when the other markets pick up again, I think some of the money will move into more attractive areas,” he says.

He says the true test will come when investors who are new to this market experience the first substantial catastrophe losses. He foresees that the ebb and flow of capital then will be more pronounced than in the traditional market.

“Let’s wait to see what occurs when the first big loss happens, because I don’t feel that all this capital is ‘intelligent’ money. A big loss is always a good test.

“The market mechanism is there to stay, and is quite efficient. I expect it to be a segment of the market going forward and I would expect the fluctuation of capacity to be far stronger than in the conventional reinsurance market, where there is more stability because of the business we are in.”

But while some reinsurers are philosophical about the effect this is having on rates, some of the service providers are more forthright. Kevin Lee, vice president and senior credit officer at ratings agency Moody’s, said in Monte Carlo in September that the rapid growth of the catastrophe bond market is posing a real and tangible threat to traditional reinsurers and leading to a commoditisation of the property-catastrophe market.

“The rapid growth of the catastrophe bond market is posing a real and tangible threat to traditional reinsurers and leading to a commoditisation of the property-catastrophe market.”

That is bad news, he said. Catastrophe bonds are eating into what he called the “sweet spot” of reinsurers’ catastrophe business—the peak risk business from which they have traditionally made very good profits in the past. Lee also noted that they struggle to compete with the fact cat bonds are fully collateralised. Some of the disadvantages of cat bonds outweigh the advantages for some cedants, he said, but added that other forms of alternative capital such as sidecars provide a “silver lining” for incumbent reinsurers, allowing them to substitute underwriting for a more stable fee income.

He cited Bermuda reinsurers specifically as a group that are using these vehicles to plan ahead and protect their businesses in the event that they cannot capitalise through public equity markets.

Lee said he expects the influx of hedge fund capital that has entered the industry to remain but, over time, it may target different classes of business. When the casualty market inevitably picks up, he said, so will interest from investors.

Hedging their bets

Although some players remain sceptical of the positives, the majority of market participants are keeping a foot in each camp on this issue. Take Hannover Re, for example. The reinsurer has long been a supporter of the growth of ILS, uses the structures itself and even has its own ILS division. But the reinsurer also has very traditional roots and these come through when considering the pros and cons of this form of risk transfer.

Ulrich Wallin, chief executive of Hannover Re, said in Monte Carlo that the convergence of traditional and non-traditional sources of capacity in the reinsurance market can be overstated. And he cited two reasons why he believes this form of capacity will remain secondary to traditional capital for the time being.

First, much of it is focused purely on short-tail property-catastrophe business, generally covering peak catastrophe risks. He admits that this has moderated rate increases in these lines but its effect on wider pricing in the market is limited.

“It impacts only a small part of the market—collateralised products lend themselves predominantly to that,” Wallin says. “Without it, we would certainly see a higher adjustment of rates but there is a lot of demand and we would certainly not lose business because of it.”

He also cites structural problems inherent in financial products such as catastrophe bonds that mean they will only complement traditional reinsurance capacity, rather than replace it. He notes that while fully collateralised products are superior in that buyers acquire no credit risk, they are inferior in certain types of loss scenarios.

“Specifically in a developing loss situation, the way some are structured is not ideal,” Wallin said. “The nature of these products means that losses are established quickly and capital released. But where there is a late development of losses it becomes unclear if the capital will still be available to pay those.

“If the reinsurer wants to renew the deal but losses are developing, are you asking it to double up the capital? This problem applies only in certain instances but the legal clarity is not always there.”

He stressed that only a small proportion of deals have this problem and it occurs only when losses are partial or developing. But he says the benefits of a traditional reinsurer’s promise to pay should not be forgotten or its strength underestimated.

“In comparison, a promise to pay is indefinite,” he says. “We have had instances where we have increased reserves for a claim, 10 years after the event itself. From that point of view, it is superior.”

Love or hate the concept, it seems a regular flow of capacity from the capital markets is very much here to stay. The main questions revolve around the extent reinsurers can be involved in this process, the effect this will have on rates and whether it will lessen when wider economic conditions change—or in the event of a big loss.

Only time will tell how these questions play out. The real challenge for reinsurers will be how, and whether, they look to participate in this new capacity and, if not, how they set themselves apart in terms of what they offer going forward.