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What impact has capital influx had on the dynamics of the insurance-linked securities (ILS) sector and its market participants?
We’ve seen a welcome increase in reinsurance capacity reflecting the greater interest amongst investors to explore this area. There have been obvious effects such as the downward pressure on reinsurance pricing and I would say there have been clear waves of activity that have impacted the market.
The initial capital influx put significant pressure on reinsurers but they have responded with innovative methods for capturing the new capital that is entering the sector; including the increased use of sidecars to lever off their existing comparative advantage to sponsor ILS deals. Some traditional reinsurers have opened up asset management arms to be involved in ILS portfolio funds. The second welcome innovation is the increase in the issuance of instruments with indemnity features rather than an industry index trigger. Supervisors always have a fixation with the possibility for there to be basis risk within these structures and to some degree, indemnity type instruments close that gap.
Do you think the downward trend in pricing is a short-term blip or this set to be the long-term market change?
It depends on how "sticky" this influx of funds might be, particularly when we consider that the market isn’t fully mature. We had a market that was growing dramatically, we had the crash, the market went very quiet and now we are seeing the market start to grow again but, in the context of broader asset markets where often yields on safer assets are very low. It’s hard to say yet if the developments are permanent and the jury is out on whether a reversal will happen.
How can traditional reinsurers integrate capital better into new investment vehicles and what can they expect from the regulators?
If you think about what comparative advantage a traditional reinsurer has there is nobody better in terms of understanding reinsurance risks, the management of those risks, evaluating reinsurance deals and pricing them. So far reinsurers have tried to utilise this by sponsoring deals and diversifying their activity towards an asset management type of role, which of course moves them away from core reinsurance. Then there is also the use of sidecars which over the last few years have resulted in quite a lot of issuance, particularly on a global basis. Product design is another issue although perhaps that has become a little easier in some ways because of the increased appetite for indemnity type products amongst investors.
One of the key fixations that regulators have with regard to risk transfer methods, like securitisation, is its purpose. The number one issue revolves around whether risk is actually transferred and whether there really is mitigation that can be captured by the ceding insurer.
This is very much embedded in the treatment of risk mitigation in Solvency II where there are qualitative criteria set down in terms of what’s to be expected in relation to contractual arrangements to improve the enforceability of risk transfer. Solvency II provides a much clearer framework across multiple jurisdictions with a more consistent and integrated approach to the supervisory treatment of risk transfer.
There is also the issue of the purpose of the risk transfer. There are different ways that securitisation type instruments can be used and supervisors are much more comfortable when they see it used for actual risk transfer and balance sheet management rather than for funding; funding-type arrangements will always scrutinised much more closely by the supervisors.
The other issue is around the actual vehicles used to transfer risk so when we think about things like reinsurance, special purpose reinsurance vehicles (SPRVs) it’s very important that they are properly authorised and supervised. Investors and insurers have to be sure that when risk is transferred to an entity that is properly regulated, authorised and subject to solvency requirements that ensure there’s adequate capital within the system to support these sorts of risks. In reality the risk may go off the balance sheet of a given firm but it will still remain within the broader financial system, and so for regulators, it’s important that wherever it’s end destination is, there is appropriate capital there to support the risk.