Collateralised reinsurance is becoming the dominant source of ILS capacity

08 April 2015

Written by Dominic Wheatley

The attraction of reinsurance as an asset class has transformed the industry over the past five years, writes Dominic Wheatley of Guernsey Finance. 

In the low interest rate environment, property catastrophe insurance business has offered stable returns that are uncorrelated to the wider financial markets.

As a result, a growing number of investors – including pension funds, high-net-worth individuals and sovereign wealth funds – have begun to allocate small percentages of their assets to insurance risk, mostly catastrophe risk.

An estimated 15% of total reinsurance capacity is now third-party capital, a figure that is in excess of 20% for the US market. This so-called “new money” is here to stay, according to Fitch, which warns “the growth of alternative capital represents a structural change to which reinsurers will be forced to adapt”.

Much of the new capital is being deployed into collateralised reinsurance. Unlike the “promise to pay” traditional reinsurance market, here the risk underwritten is fully collateralised by institutional investors.

Sources of collateralised capacity include insurance-linked securities (ILS), hedge fund reinsurance companies and sidecars. Collateralised reinsurance overtook catastrophe (cat) bonds as the dominant source of ILS capacity in 2013. Among its attractions are it offers investors the ability to diversify their exposures away from the peak US catastrophe zones – Florida wind, in particular – that dominate the cat bond market.

Collateralised markets use transformer vehicles, for example segregated accounts in a protected cell company (PCC) or incorporated cell company (ICC), that are usually not rated by the rating agencies – one reason why collateral is placed in advance. However, they are quicker, easier and more cost-effective than a standalone special-purpose vehicle (SPV).

Expanding universe

While initially only the larger reinsurance buyers dipped their toes into the alternative market, the accessibility of collateralised re has seen this universe of buyers expand considerably, particularly as prices have come down.

In contrast to other forms of ILS, particularly cat bonds, cedants do not need a critical mass to access risk transfer in the form of collateralised reinsurance cover. There are also no additional costs incurred in accessing collateralised capacity in comparison to capacity include insurance-linked securities (ILS), hedge fund reinsurance companies and sidecars.

There are also no additional costs incurred in accessing collateralised capacity in comparison to traditional reinsurance purchases. The product is essentially the same as traditional reinsurance and, from an execution perspective, is much easier to conclude than a full-blown cat bond.

For many cedants, particularly those with catastrophe exposures, a mix of rated capacity and collateralised capacity is ideal, as it offers diversification in claims paying capacity.

A growing number of collateralised capacity providers cater to the smaller insurance companies and mutuals that do not typically buy from the big ILS funds and also lack the scale to bring a cat bond to market. Reinsurance brokers are also increasingly offering both forms of cover at renewal dates.

There is also the argument that buying collateralised reinsurance reduces counterparty credit risk. Having funding sitting in a trust account can be very heartening and secure for a buyer at a time when a traditional counterparty could lose its A rating.

Indeed, the impact of the new money on reinsurance rates on line is inevitably being felt. The influx of third-party capital and growth of alternative capacity has exerted downward pressure on pricing. While a challenge for reinsurance companies, softening rates are undeniably good news for cedants.

It is perhaps unsurprising collateralised reinsurance has found a natural home in Bermuda, the Cayman Islands and Guernsey, domiciles that have well-established insurance markets. The existence of re/insurance expertise, investment funds, fund managers, brokers, captive managers and service providers has seen the alternative risk transfer market flourish in these centres.

While Bermuda and Cayman are ideally placed for capacity focused on US catastrophe perils, Guernsey is fast becoming a hub for collateralised reinsurance business in Europe, with its proximity to London and Zurich. This is reflected in the latest insurance registration figures, which show that 85 new international insurers were registered in Guernsey in the year to the end of December 2014.

PCCs and ICCs are leading the charge, many of them used by ILS specialists or reinsurers looking to transact reinsurance contracts on a fully-collateralised basis. Lloyd’s re/insurer Barbican is one example. In September 2013, it launched a specialty reinsurer on the island to focus on business that could not be underwritten in the Lloyd’s market.

It is worth noting that in Guernsey, collateralised reinsurance activities have not been restricted to property catastrophe risk. There are approximately 100 protected cells across four different PCC platforms writing fully collateralised reinsurance business to indemnify marine, crop, life and property catastrophe risks.

Protected cells have been used for writing collateralised re for around a decade and are still the vehicle of choice. That’s testament to the robustness and efficiency of these structures.

ICCs are now also being set up to conclude collateralised re but that tends to be dedicated platforms set up by a particular ILS fund, rather than an open market move towards incorporated cells as the structure of choice.

In Guernsey, the preauthorisation of protected cells conducting collateralised business has improved timescales for investors looking to deploy capacity. Guernsey’s regime is now being enhanced further by the imminent publication of specific guidance notes on the use of transformer vehicles for insurance and reinsurance business.

This is just the latest development in Guernsey that demonstrates the island’s forward-thinking approach to providing an attractive domicile to ILS and, in particular, the fast-growing collateralised reinsurance sector. 

An original version of this article was published in Insurance Day, March 2015.

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