Martin Davies analyses the state of ILS investment, how different players make price comparisons, and the impact on the reinsurance markets.
For the reinsurance market, the year 2005 will always be “the year of the hurricanes”. It was also the year the market in Insurance Linked Securities (ILS) became a permanent part of the reinsurance world. ILS investors reaped the benefits of high reinsurance pricing throughout 2006 and 2007, followed by softening into early 2008 in the absence of losses on the scale of 2005. Large sums of money flowed into ILS funds and other market participants, and this flow has continued.
No one knows how much reinsurance risk enters the ILS market. Public transactions are a matter of record but ILS investors are increasingly participating in private placements and dealing directly with issuers. Some have established reinsurance companies to access untapped and diversified sources of insurance risk. Published figures understate the influence of ILS investors.
What determines the price of reinsurance – or of ILS? As with every product that is subject to market forces, the pricing is determined by supply and demand. But that is only half the story.
In part, the price is driven by the expectation of losses. Although perceptions of loss probability ebb and flow over time, market participants use the same tools and methods of calculation and are generally in agreement in quantifying what may be termed the “base cost” of risk (which also needs to take into account the effects of expenses and investment income).
The other element in the price consists of the reward required by the risk taker, over the base cost, for accepting the risk. In ILS terminology this is often referred to as the “Spread” over expected losses. It has also been described as “reluctance” – specifically, the cost of overcoming the reluctance to put capital at risk. Dembo and Freeman, adopting an opportunity cost approach in their book Seeing Tomorrow (1998), characterised it as “regret”. A risk premium is required to compensate for the regret that will be experienced if a transaction is less profitable than an alternative. Clearly, the Spread is more subjective than the quantification of the base cost – and more sensitive to changes in market sentiment.
ILS pricing is transparent. ILS prospectuses are widely available and investors are known to be users of mainstream reinsurance modelling services. On the surface, the investing decision appears to be similar to traditional underwriting. It is also apparent that ILS investors have been careful to avoid anti-selection and have seldom undercut the traditional market. Nevertheless, in the absence of other factors, we might expect the weight of ILS capacity to reduce reinsurance prices.
In a number of ways, however, the perspective of the ILS investor differs from that of the reinsurer. Although the calculation of the base cost may produce a similar number, the assessment of the Spread required may be driven quite differently.
One difference in perspective is that ILS issues are frequently assigned investment ratings based on the rating company’s assessment of the probability loss. Once rated, the ILS can be compared with a multitude of unrelated investments. Until mid-2007, this often had the effect of making ILS pricing look very attractive to investors outside the sector. This attracted new capacity and eased pricing. When credit spreads soared later in 2007, this reversed.
In order to provide issuers with acceptable security, ILS issues have typically been backed by collateral representing the maximum reinsurance limit available. This is a very capital intensive way to sell reinsurance. Because of their diversified portfolios, reinsurers can hold capital that is a small fraction of the aggregate reinsurance limits they provide. This disadvantage has tended to prevent the pricing of ILS issues falling excessively. When, in the late nineties, the reinsurance market softened to the extent that ILS issues became inefficient, capacity largely withdrew. Where investors remained, they justified their higher pricing by observing that a collateralised product provided superior security.
Collateral has meant that ILS investors have had less incentive to diversify than reinsurers, which have chased rates down in some territories in search of the portfolio diversification needed to reduce capital. Recently, however, as ILS issues have broadened in scope, ILS funds have tended to seek the same diversification and therefore encouraged the same downwards pressure on pricing.
Another development is that banks have started to lend against ILS portfolios. This allows investors to leverage their positions while still providing full collateral. If they can achieve leverage superior to that of conventional reinsurers, they can afford to undercut them. Leverage allows risk to be taken at very fine margins. The toxic effects of excessive leverage in the investment community, however, are now only too well known.
Where ILS differ greatly from reinsurance contracts is that they can be traded -while reinsurance is held until expiry. Although liquidity varies between ILS issues, there is a generally healthy secondary market. This allows investors to move in and out of the market and to reverse decisions. Liquidity allows an investor to change its mind – thereby reducing the impact of “regret” or “reluctance”. As liquidity grows, this will have a significant impact on ILS pricing.
We are in the early days of ILS transactions. To date, the sector has done little to affect broader reinsurance pricing. But, in the longer term, the effects of leverage, liquidity and depth of capacity, as they develop, may affect the market profoundly.
Martin Davies is a Director at Towers Perrin Capital Markets and responsible for capital market related insurance transactions with Towers Perrin’s reinsurance business