The reinsurance industry is still coming to terms with the influx of financial investors into the industry via insurance-linked securities but it needs to do so quickly, as they are here to stay, argue Leon Beukes and Graham Fulcher
The rise in popularity over recent years of insurance-linked securities (ILS), such as catastrophe bonds, collateralised reinsurance and sidecars, among institutional investors has created one of the biggest shake-ups ever of the insurance industry's capital structure, with billions of dollars of new capital flowing into the industry.
The fallout from institutional investors - such as pension funds - becoming increasingly important risk capital providers to the reinsurance industry has been felt most keenly in traditional catastrophe reinsurance premiums, with consistent annual renewal reductions of 10% plus. Nevertheless, some within the reinsurance stakeholder community have consoled themselves with the belief that two main factors will eventually cause the ILS bubble to burst and, as a result, insurance rates to recover.
The first such factor would be a significant level of natural catastrophe insurance losses. It is, indeed, true that the growth of the ILS market has coincided with a remarkably benign period of natural catastrophe insurance losses, particularly in respect of major US catastrophes, such as hurricanes and earthquakes, which still dominate the exposures underlying ILS.
The second factor is that many in the reinsurance market anticipate that a return of interest rates, from their current historical lows to conventional levels, will cause financial investors to lose interest in the ILS market and concentrate their investment into traditional assets such as government bonds.
Two key questions, therefore, have arisen.
* Will pension and other financial investors move away from the insurance industry when impacted by a major natural catastrophe?
* What will happen if interest rates increase and make conventional asset classes relatively more attractive to investors?
In considering these questions, the reinsurance industry, not unnaturally, tends to look at these questions with a reinsurer's perspective and rationale. However, their business and financial model, motivations and cost of capital are typically vastly different from those of the financial investors in ILS.
For the investor's perspective, one has to start by revisiting the key reason why organisations like pension funds started to invest in insurance strategies in the first place.
For most financial investors, ILS are a diversification play and satisfy their need to balance the investment in equity and credit markets that tends to dominate most pension fund asset portfolios.
Catastrophe insurance, if done correctly via vehicles that provide a pure exposure to the insurance premium and insurance risk, provides excellent diversification as returns are expected to be largely independent from traditional asset classes such as major equity and credit markets.
As the global financial crisis showed, diversification between traditional asset classes can be very limited in an extreme event, and this only increases the attractiveness of assets such as ILS that are immune to a major and simultaneous worldwide credit crisis and stock market sell-off.
Secondly, it is worth focusing on the cost of capital point and recognise that returns from ILS instruments are consistent with the needs of financial investors. While reinsurance companies have a high cost of capital, which means they require high levels of return for accepting catastrophe risk, this is not the case for institutional investors such as pension funds.
Pension funds that hedge their liabilities typically have their return-seeking portfolios referenced against LIBOR and would generally be satisfied with investment returns of around LIBOR plus 3%. While reinsurance premiums may have contracted in recent years, current levels of implied returns remain attractive for pension funds even if not to the reinsurance industry which, due to its tail concentration of catastrophe risk, requires much higher risk adjusted returns.
This attractiveness will not reduce if LIBOR increases, as many ILS are referenced or linked to LIBOR, so that securities that are collateralised would have an interest-earning component that would rise alongside any relevant interest rate increases. Even though real returns on other asset classes may go up further in the event of a rise in interest rates,
the diversification and real return objectives of pension fund investors in ILS would not change, making it unlikely that there would be a significant shift out of ILS.
Another draw for financial investors is that the reinsurance asset class has become more accessible and 'institutionally friendly'.
Initially the asset class was seen as a niche hedge fund strategy, with ILS providers not directly targeting high-quality institutional investors and products generally not being suitable as a result. However, in recent years, investment consultants have engaged with various asset managers specialising in running portfolios of ILS instruments in order to set up new funds with characteristics that are more in line with what institutions like pension funds require.
* Lower risk/return products charging much lower fees - often a flat fee rather than typical expensive hedge fund fees.
* Products that are more scalable - for example, given the large size of pension fund investments, the funds need to have enough capacity to absorb larger allocations without negatively impacting returns.
* A quality infrastructure to service and support demands of institutional investors. For example, being able to set up managed accounts and accommodate reporting and regulatory requirements from clients such as the Employee Retirement Income Security Act in the US.
Alongside the growing ease of access, in countries like the UK we have also seen greater acceptance of reinsurance investments among the community of pension fund trustees of medium-to-large schemes.
Many of these trustees have received training on reinsurance investments from consultants and ILS managers to gain a better understanding of what drives returns, and more importantly of the (left-tail) risks involved when making these investments. This is an important factor in the potential 'stickiness' of ILS investments, ensuring that trustees will not be shocked - to the extent that they feel it is not what they signed up for and would look to immediately disinvest as a result - by negative returns in the event of a large natural catastrophe triggering losses.
Furthermore, reinsurance investments are typically a small part, around 2%-5%, of the assets of a pension scheme, thereby limiting the overall impact on the scheme of a large catastrophe loss. Rather than reacting negatively and irrationally to catastrophe losses, most pension funds that currently allocate funds to reinsurance would be likely to react more logically, by topping up their reinsurance holdings after a major event in anticipation of potentially improved premiums.
For all these reasons, the case for arguing that the funds that have flowed into the reinsurance asset class from pension funds and other institutional investors in recent years are there to stay appears to be growing stronger by the day. Longer term, there is even an emerging point of view that the ILS market could bring greater stability of capital and premiums to traditional reinsurance business.
While the ILS market's growth spurt has been painful for the conventional business models of many reinsurers in particular, it doesn't have to trigger a longer-term malaise. Already we have seen examples of the growth of the ILS market, either directly or indirectly, fostering innovation among reinsurers in many areas. For example: launching their own ILS investment funds; issuing ILS that give exposures to different insurance risks, both by insurance class and geography; establishing new hedge-fund-backed reinsurance vehicles; or new approaches to product design and pricing based on advanced analytics.
The fact that reinsurance as a pure asset class is attracting ever-increasing levels of interest and investment from institutional investors, should, in our view, be good news for those working within the (re)insurance industry that retain an open mind. Any organisation that can offer a specialist set of skills, such as the ability to access, price and package insurance risk, should be in a great position to take advantage of the capital in-flows to the industry.
Parts of the insurance industry have, to date, talked themselves in to an opposite, defensive mindset and need to find ways to embrace, assist and benefit from the new and expanding breed of purely financial investors that ILS vehicles have brought into the industry.
Leon Beukes FIA is a director of hedge fund research in Towers Watson's investment practice.
Graham Fulcher FIA is UK and Ireland managing director of Towers Watson's insurance practice