ILS Transparency Wins Investors

Since we last spoke in 2018, the public ILS market has increased at a compounded annual growth rate of 13%; however, we have no information on private collateralized transactions. How large is the actual ILS market, and what has changed in the past four years?

As you said, the collateralized transactions that happen privately are difficult to measure. There is around $100 billion in the market, or about two to three times larger than what is publicly available. However, despite the $100 billion valuation, I still believe this is a market in its infancy and with the opportunity to become a $1 trillion market.

When it comes to trends, most transactions are bespoke, so the market is much closer to a private market than to a public market. In fact, as you pointed out, you cannot find much information on the statistics, sizes, prices or even participants within the market. This isn’t a surprise to me because, in order to transition to a large public market, risks need to be transparent and standardized for investors.

This is something that we at Ledger Investing have been focused on since our inception. Since our first transaction in 2019, we’ve worked with many players to invest in our long-term strategic view and to help them “dip their toes” in the market. Recently, we’ve been able to attract large amounts of capital from strategic and sophisticated institutional investors, which are at the base for the creation of a transparent and standardized public market.

From an investor perspective, what does transparency and standardization look like?

From the perspective of the investors providing the capital (or the demand side), the solution is simple: risk transparency plus standardization. This has been their request for at least a decade, but it isn’t available in the market—other than in the P&C area we focus on.

In order to make the risk transparent, we developed a completely automated infrastructure that allowed us to remain up to date on an MGA’s policies and claims. That way, whatever information the MGA received, we received too. That automated infrastructure is still at the core of our business, because it allows us to model risk in a much more objective and standardized way.

What about from a supplier perspective. Are insurers always open to transparency and standardization, which requires them to share data on policies?

On the supply side, we work primarily with MGAs instead of insurers. MGAs are specialists in their target market, but, most importantly, they don’t have any cultural inertia about diversifying their sources of capital. Raising capital is an existential threat to them, so they don’t hesitate at the idea of sourcing capital directly from capital markets. We’ve had a huge outpouring of interest from MGAs.

From a transparency perspective, we always present aggregated information on a portfolio basis, so there is no risk for suppliers to have their practices or pricing models reverse-engineered. While insurers may be more hesitant in sharing data with us, MGAs see this as an opportunity to differentiate themselves from the industry average.

Why do MGAs see transparency as a comparative advantage?

Mostly because it’s a great way for investors to distinguish between more and less skilled MGAs, which leads to “better” MGAs to be priced above the industry average.

We’ve seen many MGAs complain about the current lack of transparency in the market. When they do business with a reinsurer, they are given rates based on the industry average, even when they can show that their loss ratio is in the low 30s. This happens because reinsurers, in this scenario, don’t have data from the individual MGAs, so they base their decision on an industry standard.

When MGAs do business with us, they are so eager to share information that oftentimes we have more details than we’d need. For example, when we’re doing commercial auto, we’re often given access to telematics data. We think that the ability to provide risk transparency is a critical driver of growth and that investors will value it strongly.

Why are insurers averse to transparency and securitization?

Mostly it’s because of the cultural inertia regarding what an insurance company is and how an insurance company increases in value. The belief is that the larger the balance sheet of an insurance firm, the more valuable it is. Ultimately, the insurance industry sells a promise of repayment, so the bigger the insurance firm is, the more likely you’re perceived to be able to satisfy that promise. This is completely understandable, and it has been true since the start of the industry. However, nowadays, securitization allows an insurance company to continue to satisfy its obligations with the same level of confidence but have much more flexibility in its capital structure.

Insurers also value their data on policies dearly and continue to believe that if somebody got a hold of their information they would be at a disadvantage. It may be true in some very limited instances—when you have some “secret sauce”—but, for the most part, there is no way to extract any strategic advantage from that kind of information.

The lack of transparency, other than discouraging investors, creates some difficulties when dealing with other companies within the insurance industry—for example, with reinsurers. When I was a chief reinsurance officer at AIG, I’d always see a difference in market pricing between us and the reinsurers when it came to, for example, cash treaties, due to the different views on expected losses. In some cases, the price difference is simply because one side of the deal wants to make a larger profit. But in most of the cases I’ve experienced, it’s due to reinsurers’ lack of substantial information, which leads them to use conservative assumptions for the model and, thus, price products much higher than they’re supposed to.

How can you convince insurers to change their capital structure?

They just need to check it out in order to fully understand its benefits. Even institutional investors, which are very forward thinking, felt the same way, so they also tested it out slowly. If they have a $200 billion fund, they’ve probably started with a 3% investment just to experiment and see how it works.

I still think that MGAs will lead this innovation, because insurers have a lot of overhead and are, in this situation, much less efficient. Insurers don’t lead innovation, but they’re very strong followers, so as soon as something starts happening, insurers will follow suit.

What will the industry look like once insurers make the transition to ILS?

In that scenario, I believe that the traditional view of an insurance industry will cleave itself into two kinds of insurance firms.

The first kind will be purely customer-facing, dealing directly with the buyer and with all the touchpoints with the person buying insurance. The origination of the risk, underwriting the risk, and the pricing of risk from managing the claims need to be much closer to the customer. This part of the market—which I call risk origination—will be extremely fragmented because of the high levels of specialization that customers will require for their businesses and technologies.

The other insurance firms will deal with the entities that provide capital. In my mind, a licensed insurance company that can issue a policy and warehouse the capital—or holding the capital to finance a risk—lends itself perfectly to commoditization. In a commoditized market, the way to make money is to scale up, so consolidation remains a large part of business growth.

You can see this phenomenon already happening in the market. In the risk origination side of the market, the number of MGAs has continued to grow, as they’re now very specialized, very entrepreneurial, and very technology driven in order to penetrate certain markets. While on the other side of the market—the cat bonds market—there’s a lot of capital off balance sheet, and it’s being consolidated with large institutional investors.

Has the recent focus on climate change risk impacted the ILS market?

For many reasons, it’s extremely difficult to know how much climate change risk is priced in within the catastrophe bonds market. However, from my experience, climate change risks have definitely impacted the decision making—and, thus, investment decisions—of many investors. Most of the investors we talk to are very experienced in insurance and have been investing in cat bonds for a long time. Part of the reason they’re coming to us is that they see us—instead of cat bonds—as a growth opportunity. They clearly feel uncomfortable with the market’s ability to assess or price climate change risk correctly.

What other trends are evolving from the ILS market?

Right now, there’s a lot of interest around the volatility of loss ratios in the casualty market. For one, loss ratios are public information, but they are mean reverting, meaning that, despite the short-term volatility, the average loss ratios will remain similar in the long term.

For investors, this is a much better risk profile, as you know that loss ratios will remain within a range and foresee when the trend will shift. Our models can be back-tested, and they’re made transparent to investors so they can understand the strengths and weaknesses of the investment. Oppositely, cat bonds are very binary, so it is extremely difficult to know if there’s any frequency aggregation or what the long-term trend is. Cat bond modeling is also not transparent—we call it the “black box”—which doesn’t allow investors for back-testing.