Alternative capital is ready to innovate

Alternative capital grew again last year but at a slower pace. Paul Schultz, chief executive of Aon Securities, suggests to PCI Today this growth will continue but innovation will also be needed in the long term.

By the end of the first half of 2016, alternative capital in the re/insurance industry had reached $75 billion, and while its pace of growth has slowed compared to recent periods, it is noticeably becoming ever more intertwined and integrated with traditional re/insurance. However, experts point out that the long-term growth of alternative capital will depend on its ability to innovate.

These observations and other findings form part of Aon Securities’ recently launched annual insurance-linked securities (ILS) report. This year, the report is aptly titled Alternative Markets Find Growth Through Innovation.

The report reveals that $72 billion of alternative capital was deployed in the industry in 2015—12 percent more than a year earlier. Paul Schultz, chief executive of Aon Securities, says that while this growth is meaningful, it is somewhat lower than that of the 2014 calendar year, during which third party capital increased by 28 percent.

“Growth is slowing a little but the traditional market is increasingly seeing this capacity less as competition and more as a complement to its growth objectives. Re/insurers are using it for their own means as an efficient form of capacity, and changing the mix of how they fund their own balance sheets,” Schultz says.

He says most of the growth in the market has been through the increased use of collateralised structures as opposed to the issuance of ILS.

Schultz also notes that although the cat bond market has not grown year on year, innovation has been occurring within the sector, with a greater variety of perils now being covered and terms of coverage moving ever closer towards those offered by traditional reinsurers.

“The terms and conditions have changed and the wordings are converging with the traditional markets. That makes it easier for clients to match risk transfer solutions and take a more integrated approach,” he says.

He notes that there remain ‘frictional’ costs around ILS transactions, which will inhibit their use for routine hedging transactions. In contrast, it is much easier to procure collateralised reinsurance via a fund or sidecar.

“It is simpler and easier for clients to utilise collateralised reinsurance, meaning its usage will likely continue to expand,” he says.

He says that for the bond markets to grow, these frictional costs will need to be reduced and the product will need to be priced in a way that is comparable with the collateralised product.

“There is a tremendous amount of capital available in this space should the demand side increase,” Schultz says.

He notes that his team’s ILS annual report also reveals that total returns of cat bonds in the 12-month period to June 30, 2016, outperformed almost any other benchmark or investment available, including US Treasuries and the S&P 500. He says that only high yield bonds were able to match the returns available from cat bonds. “But the uncorrelated nature of cat bonds increases their appeal over other asset classes. This means there remains capital willing to move into this space,” he says.

Innovation needed

Going back to the theme of the report, Schultz says that he expects the alternative market to continue to grow as long as there is continued innovation around the types of products available and the perils they cover.

“It is very likely that the market will begin to broaden in terms of the perils covered and the structures used,” he says. “As a market, it has always focused heavily on property catastrophe business and notable short tail risks. In this regard, it has been well matched to the capital requirements of investors, but we believe that alternative capital will now start to move into specialty lines, including marine and aviation risks, and even into forms of operational risk or casualty risks in some instances.

“We also anticipate more focus on creating financial solutions for clients as well as offering capacity.”

He adds that this situation will increasingly mean a greater choice for buyers and a willingness on their part to create more holistic solutions than in the past.

“The choice available to them will be greater than ever and their sophistication will continue to increase,” Schultz says. “We will see more capital entering this space and more innovation around how that capital is put to work. We believe that a situation where different markets compete for capacity will also deliver to clients the best product and the best price, as well as offering diversification.”

Paul Schultz is the chief executive of Aon Securities. He can be contacted at: paul.schultz@aonbenfield.com