It’s time to analyse the next stage of ILS
In the wake of the global financial crisis, the convergence of capital and reinsurance markets and the ever-increasing use of insurance linked securities (ILS) are positive indicators for the future of the insurance industry, write Appleby partner Timothy Faries and associate Gavin Woods.
Bermuda is at the vanguard of the ILS movement. This should not surprise insurance industry insiders – Bermuda has always shown a willingness to be at the forefront of developments in the insurance industry and has a rich history of innovation.
Also, in contrast to many of its offshore competitors, Bermuda provides a fortuitous environment to reinsurers, and has become the world’s third largest centre for international reinsurance, estimated to provide more than 50% of the worldwide property catastrophe capacity to the market.
In the 1980s, following the worldwide withdrawal of high risk/low limit general liability capacity, ACE and XL were formed to offer excess liability insurance. In the 1990s and 2000s, lack of property catastrophe capacity, the devastating losses arising from the terrorist attacks in New York and Washington, and the impact of Hurricanes Andrew, Katrina, Rita and Wilma led to billions of capital being raised and contributed to a rise in new reinsurers.
The capital capacity of reinsurers during this period was partly due to increasing access to the capital markets through the issue of ILS. Today, amid rate increases, disillusionment with low investment returns and increased regulation, ILS account for more than 14% of global catastrophe reinsurance capacity, with a valued of more than $15bn. Many suggest that its growth is impervious to rate changes and even a large loss.
Bermuda is at the heart of the ILS revolution. The island’s primacy in this field is perhaps unsurprising given its status as the world’s top domicile for captive insurers; it has become the world’s third largest centre for international reinsurance, estimated to provide more than 50% of the worldwide property catastrophe capacity to the market. Bermuda was also instrumental in creating a new classification of insurer: the special purpose insurer (SPI).
An SPI is typically a single transaction/customer reinsurance company that may only assume obligations necessary to give effect to the special purpose for which it has been established. Its exposure to such risks is fully funded by a variety of means, a common one being through the proceeds of a debt issuance, with the repayment rights of the providers of such debt subordinated to the reinsurance obligations of the SPI. Increasingly, SPIs are used for collateralised reinsurance transactions, the full funding being achieved through the establishment of collateral accounts with a trustee which covers the totality of the risk exposure under the reinsurance agreement. The fact that its obligations are fully funded means that an SPI is not at risk from insolvency. As a result, SPIs enjoy an expedited and streamlined application and supervisory process (for example, SPIs are not restricted from declaring dividends, reducing capital or otherwise releasing funds), which is reflected in a relatively low and competitive registration fee of $6,000 and a minimum capital requirement of only $1, and is commensurate with the low regulatory risk profile such fully funded vehicles represent.
These SPIs are very much being put to work. Over the same period, Guy Carpenter reports that the ILS market created approximately $10bn of new capital. A recent report from Willis Capital Markets & Advisory indicates that ILS issuances for the first two quarters of 2013 touch $4bn.
The demand for alternative capital shows no signs of abating. Traditional reinsurers have been pushed on pricing due to the flood of institutional investors in the market who are ready, willing and able to lend their capital to eager sponsors. It has certainly not been the time to remain complacent, with the demand for alternative capital only being matched by innovation and speed and ease to market.
At the same time as SPIs were being introduced by the Bermuda Monetary Authority, the Bermuda Stock Exchange (BSX), the world’s largest offshore insurance stock market, recognised that as ILS was being marketed more widely to institutional investors in Europe and Asia, listing of the securities w become more important. The BSX’s president and chief executive officer Greg Wojciechowski was recently quoted as saying that the BSX took note when investors increased their investment interest in ILS, and so undertook to do its part to provide an exchange platform that would help accelerate the development of the ILS asset class and help place Bermuda at the centre of the convergence of the two market segments.
As a result, the BSX was the first stock exchange in the world to introduce a set of specific listing regulations designed exclusively for insurance securitisation products, along with a special, fast-track listing procedure for special purpose vehicles (such as SPIs) that restrict investment to qualified investors. In a recent press release, the BSX announced that the $53m share offering from Blue Capital Global Reinsurance Fund had pushed the rapidly expanding ILS instruments on the BSX beyond the $7bn mark, and at press time they had reached $8.5bn.
Insurance has consistently evolved, perpetually adapting over time to the cycles and challenges of international financial markets and industries. This willingness to adapt has enabled the insurance industry to pioneer many constructive and reactive innovations, such as ILS. While financial innovations have the potential for transience or being relegated to obsolescence by subsequent modernisation, it is clear that sponsors are continuing to seek the attractive pricing offered by ILS vehicles.
So long as that is the case, the ILS market is in for the long haul. The influx of investor capital into ILS has generated a dose of healthy competition into the insurance market, and served as an impetus for the insurance industry to up its overall game. While initially the divergence between ILS and traditional insurance products may have begun life as a conflict, this has developed into a peaceful, and vital, cohabitation. In future, it is likely we will increasingly witness an outright wedding of the two.