Black Magic

Modern financial alchemists have made the transformation of base natural catastrophe risk into a golden investment opportunity—and made it tantalizingly simple.

Under the spell of the new risk magicians, capital has swamped the international insurance market. Billions are being funneled into the insurance or reinsurance sectors, even as prices for high-level property risk coverage are collapsing. In January, Willis declared the reshaping of the reinsurance market a reality.

This dramatic restructuring of the insurance industry’s capital base is barely visible from the front lines, but it’s bound to be holding down premium rates across the board. That has a commensurate impact on everyone who earns a living by taking a cut. Some traditional reinsurers are worried the new risk conjurers hold all the cards, but others are joining their cult of convergence.

Reinsurers first tried tapping the trillions circulating in the capital markets 20 years ago, when Northridge and Hugo cut a $30 billion gash through their balance sheets. Now the financial alchemists have perfected their near-magical transformation engines. Today every large reinsurance brokerage has a capital markets division, every reinsurance buyer has looked at non-traditional reinsurance, and an army of salesmen are methodically calling on every pension fund manager in the world, encouraging them to invest 3% to 5% of their assets in insurance-linked securities, or ILS.

Non-traditional capital in the reinsurance sector reached $61.9 billion in 2014, up roughly a quarter from the previous year, according to Aon Benfield. Depending on which estimate is used, it accounts for some 12% of reinsurance capital but as much as half of the cash backing cover for mega-catastrophes. About $20 billion came into play since 2013 alone. Aon Benfield predicts the total will reach $150 billion in the next three years. Commentators agree the tipping point has been reached: 2014 was “the year that the convergence market converged,” says the ILS blog Insurance Linked.

Slowly at first, the alchemists (notably from Swiss Re on the insurance side, Goldman Sachs for the bankers, and Aon for the brokers) began to tinker. Since 2008, new boutique investment banks owned by the big reinsurance brokerages—Aon Benfield Securities, GC Securities (part of Marsh), Willis Capital Markets & Advisory and Jardine Lloyd Thompson Capital Markets—have been directing the experiments.

Early capital markets reinsurance products were expensive and clunky. Now they are cheap and flexible. The capital market’s voracious insurance-risk appetite is looking for new territory to conquer. The wizards of risk transformation have made some headway pushing capital-markets money behind casualty risk underwriting, but Aon Benfield predicts primary property insurance and business interruption will be the next sectors scorched by the alchemists’ fire.

The Horsemen

Steve Evans, the former Willis man behind the ILS blog Artemis.bm, has outlined four reasons for the recent explosion of alternative reinsurance capital. Price is out front.

“The catastrophe bond market is now often able to undercut traditional reinsurance pricing on certain risks and layers of programs,” Evans says. Paul Schultz, CEO of Aon Benfield Securities, says alternative markets “are extremely competitive and in many cases offer better value than other markets.”

Evans’ second factor is “an increased appreciation for where the true cost of ILS capital lies.” The improved transparency of the real risks lurking behind the instruments is due largely to better modeling, and has allowed money managers to fine-tune the cost of the product. “Property catastrophe models have developed to a point where capital markets are able to assess the levels of assumed natural disaster risk with sufficient reliability,” observed the U.S. Treasury in December.

Evans’ third growth factor is better coverage. GC Securities cites the incorporation of “hours clauses and definitions of named storms,” common in reinsurance treaties, into capital markets structures. Finally, alternative capital now has a measure of critical mass. Appetite for ILS is high, both as a risk transfer tools and as an investment. “Sponsors, particularly first-time primary insurer sponsors, have been keeping deal-flow moving during the year, while interest from investors continues to increase and broaden,” Evans says.

Even the most traditional reinsurance circles have seen the light. Alternative capital “is growing to a point where people are now saying we shouldn’t be calling it alternative or non-traditional capital anymore,” says Sean McGovern, Lloyd’s chief risk officer. Nephila, the largest of the ILS fund managers, has a Lloyd’s syndicate. Willis says most U.S. national carriers now use “collateralized reinsurers, sidecars, managed funds, or other non-traditional vehicles, as well as traditional reinsurers.”

All Aboard

Now mainstream, ILS operations are materializing everywhere, while investors’ broadening appetite for risk continues to expand beyond the short-order menu of Florida wind and California quake. Entropics Asset Management, a Swedish outfit, is one of the latest diners. Its new fund, approved by Luxembourg officials in December, will invest institutional money in “liquid cat bonds with a target return of four to six percent above the risk-free interest rate.”

Also in December, Swiss property insurer GVB sponsored its first ILS deal, a $70 million cat bond covering natural perils in the Canton of Bern. The bond has attracted some of Europe’s oldest money, including Hans-Adam II, Prince of Liechtenstein. His family-owned private bank, LGT Group, has a $4 billion insurance fund, LGT ILS Partners. Hannover Re fronted the deal, which was arranged by Guy Carpenter. The broker declared the cover “highly competitive to the traditional reinsurance placement.” In other words, the capital markets have undercut the incumbents.

For insurance companies, the wave of alternative capital means cheaper reinsurance. Investors see insurance risk as a diversifying source of uncorrelated income. For wholesale and reinsurance brokers, managing capital-markets investment offers a dynamic new product line. And ILS benefits the ultimate buyers of cover through cheaper premiums for the catastrophe-exposed components of their policies.

In at least one case, a sophisticated corporate insurance buyer has transferred risk straight to the capital markets. First Mutual Transportation Assurance, the captive insurer owned by the New York Metropolitan Transportation Authority, issued a $200 million, parametric-triggered cat bond called MetroCat to protect the subway operator from storm surges. Guy Carpenter arranged the deal. Finally, for reinsurers, the capital markets mean cheaper retrocession—reinsurance for reinsurers. Many traditional reinsurers have now joined the game by issuing catastrophe bonds, buying capital-markets-backed industry loss warranties, or adopting a sidecar (see “A Bluffer’s Guide to Alternative Capital”).

Routes to the Capital

Luca Albertini is chief executive of Leadenhall Capital Partners, a London-headquartered investment manager, which runs about $1.8 billion of investors’ cash and is 75% owned by the London reinsurer Amlin. Albertini explains two routes to the capital markets available to a traditional reinsurance broker. “They could go through somebody who has a fronting arrangement,” he says. “For example, we do all our business with Amlin’s syndicate at Lloyd’s.”

In this case, the broker places the business with Syndicate 2001, understanding that it will be ceded to the capital markets. The risk is then retroceded to the Bermuda-domiciled transformer Horseshoe Re Ltd., which manages segregated reinsurance accounts capitalized by Leadenhall’s investment funds. The volume of business transacted under this fronting arrangement was almost $25 million in 2013.

The other route is non-traditional from the start, Albertini explains. “If the protection buyer doesn’t want fronted or credit business, they ask for collateralized cover, where they have the direct benefit of the collateral,” he says. The broker’s capital-markets subsidiary then takes over, “because it is not a reinsurance activity, but a capital markets placement.” The reinsurance is placed directly with the fund manager, but the buyer holds the money, and thus accrues the benefits. If no claims are made, the capital is returned, along with a premium.

This bit of wizardry circumvents the challenge identified by Lloyd’s (see “Bluffer’s Guide”): since the reinsurer has beneficial ownership of the capital, at least temporarily, and the asset offsets the insurance or reinsurance liability. Both routes are popular, although the latter, known now simply as “collateralized reinsurance,” is booming. It lets reinsurance buyers avoid the credit risk associated with conventional reinsurance while enjoying the income from the invested principal.

Sidecar structures, which Willis calls “market-changing structures where primary carriers directly access capital markets,” also allow insurers to bypass traditional reinsurance markets. Some carriers should be scared or, like Amlin and Hiscox, should change their business plans. “Third-party capital does constitute a threat to some reinsurers,” says David Flandro, Global Head of Strategic Advisory at brokerage JLT Towers Re, “particularly those that are monoline and very cat-heavy. Medium-sized, rated capacity providers of traditional reinsurance are going to become a thing of the past in fairly short order.” That said, it’s fairly clear that insurers do not yet wish to place all of their eggs in the alternative-capital reinsurance basket. So far, at least, to do so is impossible.

Some alternative reinsurers “are moving into other classes,” Willis observes. Indeed, the brokerage itself is backing a new London alternative-capital platform which looks set to target MGA business.

Acappella first appeared in 2013, as the name of Willis’s new, but conventional, Lloyd’s syndicate. In January the brokerage, along with partner Ironshore (which has a one-third stake) announced that Acappella Group Holdings is to expand to include a fund manager to channel investors’ capital “into insurance underwriting businesses.” It will also operate a managing general agent that will work with individual MGA units to match risk with the capacity of carriers, including Acappella Syndicate 2014, Ironshore, or others depending on the class of business, and a full-service Lloyd’s managing agency (Acappella is currently managed by Ironshore’s Pembroke agency). It is to be totally independent of Willis’s broking business.

However, such moves by alternative capital into broader underwriting have clear limits, so it seems unlikely the entire reinsurance market will be swallowed by the capital markets.

“Asset managers would be relatively uninterested in long-tail insurance or reinsurance, as it is correlated to interest rates and inflation and is an inefficient way to gain risk exposure,” Flandro says. “I guess the line is somewhere after shorter-tail specialty business, like marine, aviation, cyber, business interruption, et cetera, and before lines like E&O, D&O, and medical malpractice.”

As well as welcoming more complex ceded risks, traditional reinsurers have another big advantage. They can offer contract conditions that collateralized reinsurers are unable economically to provide. For example, most property catastrophe treaties offer “reinstatements,” the option to reactivate a treaty (for an additional premium) after a major loss exhausts the coverage. Under a collateralized contract or a catastrophe bond, inventors would have to hand over double the principal from the outset.

Hiscox Re, another London-based traditional reinsurer, is profiting from this technical gap. Its Bermuda capital-markets transformer, Kiskadee Re, has taken flight. “A major appeal of the Kiskadee funds is their ability to provide investors with access to a more complete universe of risk,” says Richard Lowther, Kiskadee’s chief operating officer. They do so, Lowther says, by “utilizing the rated balance sheet of Hiscox as a front to access the market, one which can handle reinstatement and therefore provide investors with a much more complete universe of global property catastrophe risks.”

Despite Kiskadee’s apparent success, Hiscox has refused to follow market pricing downwards. “We have deployed $110 million of capital, less than we had expected” through Kiskadee, Hiscox says of 2013. “Capital markets investors are being more disciplined than some traditional reinsurers.” Still, as of January 1, Kiskadee’s assets under management had increased to more than $400 million, to be deployed “between now and the summer 2015 reinsurance renewal season,” Hiscox says.

Pricing: Awaiting the Big One

Some commentators have noticed a slowdown in new ILS investment, as margins narrow. Much new capital is queued up to be deployed but is waiting for better prices, Schultz says. “Investors are viewing the pricing environment as less optimal now, so they’re basically sitting there, looking to bring capital in post-event,” he says. Thus, concerns (or hopes) that a string of losses will cull investor appetite for insurance or reinsurance risk are probably wrong. After Hurricane Katrina, capital-markets demand for such risk boomed.

If the Big One hits, the ILS market may be triggered and may even see its capital wiped out, “but it should be able to reload quickly,” Flandro says. Pension fund assets top $30 trillion, a hundred times greater than the capitalization of the reinsurance sector. The annual turnover of derivative instruments is an incomprehensible one thousand trillion dollars, an amount so large we don’t even have a word for it. The financial markets can withstand a loss that would obliterate the reinsurance sector, although even the most excessive foreseeable catastrophic event is likely to destroy only what Flandro describes as “the little, marginal, unquoted, unrated companies.”

The average price of high-level property-catastrophe reinsurance—the bread-and-butter of cat bonds and other collateralized alternative instruments—slid again at January renewals, by perhaps another 10% to 15%, according to Willis. Flandro says alternative capital “does deserve some of the blame” since “more supply equals lower pricing.”

On the demand side of the equation, 2013 and 2014 were very low-loss years, which has also been a driver. In this environment, the profitability of what could now be described as “conventional” non-traditional reinsurance has taken a massive hit. Given the rush of capital into the market, and the swollen balance sheets of traditional reinsurers (driven by their retained earnings), income under ILS has been declining.

Industry blog InsuranceLinked has analyzed the return anticipated under catastrophe bonds issued in the three years since 2012. It found their expected return to investors “has fallen by well over 50% in 24 months,” although the slide in returns in 2014 was “less dramatic than the previous year.” However, Adam Alvarez, author of the analysis, notes that a concurrent spike in non-insurance junk-bond yields provides more evidence that ILS is uncorrelated with other financial investments. This independence is of utmost import to investors.

“The low correlation benefit was largely proven in the global financial crisis, where ILS returns and liquidity in secondary cat bond markets were demonstrated to be quite robust,” Lowther says. To remove interest-rate risk, most ILS instruments’ return rates float on the risk-free rate.

Investors in the securities—excluding industry players—tend to be pension funds and high-net-worth individuals, the latter with perhaps $2 billion in the market. The former, which according to Schultz provide up to 80% of alternative investment, “obviously have a longer-term horizon.” That makes a good fit: pension funds with a 100-year investment view can logically take bets on 100-year events and weather the storm if some of their capital is wiped out early on. This has engendered confidence around the sustainability of the capital and thus encouraged market growth. For wealthy retail investors, above-average returns under higher-risk ILS instruments have been tempting, but the prospect of a loss may be more threatening. “All private investors with a significant share of ILS risk in their portfolio are likely to be disappointed when the risk comes through,” Albertini predicts.

Going Long

“The future of ILS is bright!” shouts Andre Perez, Horseshoe Group’s chief executive. “Growth continues to be impressive.” He predicts that the New York Transport Authority’s MetroCat bond, issued without reinsurers’ intervention, will be a trendsetter. Indeed, it may mark the inevitable direction of things. Alternative investment is “extremely efficient in replacing expensive tail capital,” Shultz says. Carriers will look increasingly to fee income, as managers of third-party capital, he says. “We are at the early stages… We will continue to innovate.” Meanwhile, Flandro expects reinsurance brokers increasingly to provide “advisory services, banking services, as well as alternative capital and structures.” The impact will be great, and the market will look very different in 10 years.

“In fact, it already does,” he says.

The entry of the capital markets’ billions may have a long-term impact on insurance and reinsurance pricing. “There appears to have been a structural shift in how the short-tail side of the reinsurance market funds itself, and this does spill over into long-tail,” Flandro says. “This is new, and will change the depth and nature of the cycle.” Lower-priced reinsurance should lead to lower-priced insurance, he says. “The trend should begin in short-tail, and indeed it has done so in U.S. coastal areas, where wind reinsurance was extraordinarily expensive.”

Yet fears of a “permanent soft market” are overblown, Flandro believes, declaring the reinsurance pricing cycle “alive and well.” As the long-term capital of pension funds stands up, pays attention and pours money into the insurance and reinsurance sectors; as the architects of innovative capital-markets insurance and reinsurance products continue to develop new, efficient and truly useful structures; as insurers, reinsurers and even the consumers of insurance begin to place more of their faith in capital-markets insurance options; and as the convergence market as a whole matures, beds down and gains acceptance, it seems increasingly likely that the shape of the international risk transfer market has changed irreversibly.