 By Bryan Joseph, PwC Partner and Global Actuarial Leader & Marta Abramska, PwC Principle Consultant, Actuarial and Insurance Management Solutions
The reinsurance market has had a reasonably benign time since the financial crisis. An absence of market-changing catastrophe events causing big losses to the insurance industry has meant that the market has continued to exhibit good profitability for its investors. This situation has been further compounded by the very low interest rate environment, brought about by quantitative easing, which has left investors actively searching for additional yield.
Against this backdrop there has been a dramatic increase in the quantity of capital deployed into the insurance-linked securities (“ILS”) market, attracted by the higher returns of catastrophe investment instruments compared to other segments of the market, as well as the opportunity to obtain diversification benefits from an uncorrelated asset class. According to industry forecasts, alternative capital is expected to rise by 50% to $75 billion by 2016; with penetration up from today’s 15% of total cat capacity to a 25% share of the cat market. It has been forecast that a further $100 billion of capital will be deployed in the ILS market over the next five years. The growing presence of alternative capital is creating challenges such as earnings pressures and further price softening, but the persistence of a low yield investment environment poses a much larger threat to the reinsurance market.
Some of these challenges were explored in the PwC paper released at this year’s Monte Carlo Reinsurance Rendezvous, “Expanding the potential of ILS”. The paper highlighted that much of the unprecedented growth in investments in the ILS market has come from pension funds and other long-term capital. In order to get approval to allocate funds to this new asset class, the investment managers had to go through several processes to obtain permission from their investment committees. The consequence of this is that ILS is now an established asset class and the capital deployed is here to stay with, according to PwC research, a typical allocation of about 1%-2% of investible assets for these large funds. The challenge for the industry is how they integrate ILS into their business - how should they make ILS a story about convergence and expansion and not about cannibalisation?
The current premium cycle reflects that there is an abundance of capital chasing business and this has put pressure on the rates, especially in the lucrative US catastrophe segment, which has been the backbone of profitable property catastrophe underwriting over recent years. This has continued despite the occurrence of Sandy in autumn 2012, the third most expensive windstorm to make landfall in North America. ILS has played its part in this revolution with the narrowing of spreads making it more attractive for companies to consider it as part of their reinsurance stack. It has had the additional impact of expanding the market, bringing risks that were previously uneconomic to insure back to the market. PwC’s overall view is that traditional and alternative capital both have an important role in the future evolution of the industry.
How are things going to evolve?
i. Increased capacity and scope of the market. Currently the vast majority of ILS markets have been focused on North American wind and/or earthquake catastrophe covers. These are the markets with the most advanced data and modelling and therefore allow ILS companies and investors to make decisions easily. Indeed, these areas may become more commoditised with the quotation engines being fed directly from models with an overlay of expert judgement at the end. To increase capacity and scope, underwriters would need to look at areas where there is equivalent data e.g. European Wind or Longevity Trend risk and also aim to build models to allow ILS investors to participate. Indeed we believe that in certain markets such as Australia or New Zealand, the available data may be there to permit the rich analysis that supports the penetration by alternative capital. This approach would allow companies to free up their underwriting talent to concentrate on areas where there is still considerable risk but low volumes of data. These areas would include emerging markets or consideration of alternative types of exposure. It would also have the advantage of refocusing the company away from the slower growing traditional markets into those emerging markets where growth opportunities are the greatest or into sectors of traditional markets where penetration is low.
ii. Product Innovation During 2013, we have seen the partial resolution of the conflict between the sponsors wishing to transfer basis risk and the investors unwilling to accept it in favour of new products that accept basis risk or GAP reinsurance products that offer to insure the gap between ILS covers and the traditional markets for a premium. These innovations have narrowed the gap that used to exist between traditional and alternative covers and means that the market is viewing these covers as increasingly mainstream and is able to compare the costs directly between traditional covers. These are welcome developments for the industry, as this innovation leads to the evolution of the new market place – where demand could be created rather than a fight over existing placements.
iii. New perils and approaches Another feature of the recent markets is the increase in specialist and private deals; the transaction of the Port of New York Authority in relation to its risk from storm surge represents a good example of this type of arrangement. The willingness of particular sponsors to do private deals is providing an outlet for new capacity in areas where clients would have been self-insured. Moreover governments and other agencies in some developed markets have found themselves increasingly intervening in those markets to either provide covers where there has been a market failure or to protect the consumer from the full impact of price competition in the market; examples of these covers include terrorism and flood insurance. While there will always be room for the government as a reinsurer of absolutely last resort, many of them prefer to involve the private sector in providing capacity for peak losses in areas where there have been few losses but perils are increased. For ILS capacity and indeed traditional reinsurance the ability to enhance the state’s response to natural perils with a capital markets or private solution is worthwhile.
So what does this mean for the market?
The best possible outcome is the deployment of new capacity, not in a fight to the death for existing products, but to use it as an opportunity to innovate and explore new markets. The reinsurance industry has existed for years, building and enhancing its reputation by its ability to settle claims from its cedants efficiently after an event has occurred. This reputation has been hard won and demonstrated repeatedly over the past few years. It is facing a period of change from new capacity being deployed and this is not the first time this type of change has occurred. At each stage our industry has responded to the influx of new capital by accommodating it and embracing it into its ethos, providing protection and good returns to investors. A changing market dynamic is an opportunity as much as a challenge. This time it won’t be any different. The $3 billion of new capacity deployed into ILS funds in the first half of 2013 is the symptom of an attractive marketplace where return is possible. It is driving pricing adjustment and an expansion of capacity into new areas.
It is, however, a journey that will not be decided in the next few months. It will be determined by the evolution of the markets to fully embrace new capital, new innovation and the opportunity for growth.
|
