Developing a long-term strategy that matches capital with the most appropriate method(s) of deploying it has been a constant challenge for many insurers/reinsurers. Historically, the industry has had to struggle to establish and maintain sufficient amounts of capital to meet regulators’ and rating agencies’ requirements. As a result, proper deployment of capital has been difficult, especially following major catastrophic events. More recently, both insurance regulators and rating agencies have begun requesting additional amounts of capital, due to the development of more sophisticated catastrophe modeling capabilities as well as the advancement of the EU’s Solvency II and Basel III regulations.

Convergence between the insurance industry and the capital markets actually got its start about 10 years ago. Convergence started quite slowly with the introduction of CAT bonds, which were directed primarily at the catastrophic risks associated with natural disasters affecting the U.S. Since their introduction, CAT bonds have gained support from both investors and insurance buyers. Today, the array of alternative capital market approaches, known collectively as insurance-linked securities (ILS), continues to expand and mature.

The initial modest growth of the ILS market was due in large part to the frictional cost associated with bringing the insurance-linked securities to market. The newness of the product, suggested terms and conditions, and general lack of support from a traditional reinsurance community all contributed to a sluggish start. However, this changed dramatically over the next few years as both the investment and insurance business segments got more comfortable with the concept. Figures for the last quarter of 2014 show that total issuance of insurance-linked securities was around $2.16 billion. That brought the annual total for 2014 to $8.8 billion, making 2014 the busiest year on record for the ILS market.

The eye of the storm

There is little question that the interest in ILS has become a major part of today’s insurance/reinsurance landscape. But the question remains, what’s drawing the investment community towards CAT bonds and other forms of ILS? A review of the growth of the alternative capital market can provide some insight into what is driving the increased interest in ILS. Simply put, there are about four main drivers that are keeping investors interested in this market. Number one on the list is probably the lack of competitive investment vehicles. With interest rates continuing at historically low levels, most institutional investors are looking for better yields. Currently, many of the ILS products are producing results that are 5% to 6% higher than traditional investments. This appeals to investment advisors who have clients looking for better returns. Secondly, investments in ILS have been helped by the continual improvement in and acceptance of many of the contract terms and conditions as well as the development of a secondary market that helps improve the liquidity of the ILS market. Additionally, investors are also extremely interested in opportunities to diversify their portfolios, especially for zero beta investments. Typically the zero beta products are investments that have no correlation with the overall financial markets. Finally, the lack of a major CAT loss that could deplete both the investors’ earned interest and principal has also served to generate attention in the ILS market.

Innovation is constant with this market and should reinsurers wish to maintain or even expand their position, they will need to be at the cutting edge of this innovation. One way to do this is to develop the success factors that buyers are looking for. Fitch Ratings has spent significant time developing a list of factors that will affect reinsurers’ ability to attract the highest quality business that is being placed into the global reinsurance market. Following are some of the factors that Fitch indicates are important to protect any reinsurers’ market share in the event of a continuing soft market:

• Scale—helps reinsurers provide a reach that smaller competitors cannot match. Additionally, it provides the means to access business in regions where relationships and feet on the ground are major pluses. It will also allow reinsurers to see more business, so they should be able to make better decisions where to deploy capital.

• Diversity—this is closely related to scale, since only the largest reinsurers are actually global and have diverse lines of business that will allow them to move their capital to areas of the market where softening has not been as severe. The issue here is that without diversity, smaller reinsurers are either reduced to becoming a following market in some of the most competitive areas of reinsurance, or must try to produce diversification via new lines of business.

• Financial strength—a key asset to any reinsurer, large or small. It is critical in supporting new expansion efforts or new diversification efforts, thus allowing reinsurers to pull back some capital to deploy in other more profitable lines of coverage. This will essentially make a reinsurer more resilient in the short run.

Fitch points out that those reinsurers that do not have these three qualities will be the most exposed to the continuing softness in the market, or the further encroachment from the alternative capital market. Competing on price often works to the capital markets’ advantage since they frequently are able to price their products more competitively due to the efficiencies inherent in the ILS space. This is the exact approach that the smaller, catastrophic property reinsurers have noted since the advent of CAT bonds, which currently account for about 20% of that market.

What the future holds

Even a cursory review of the ILS market over the past few years shows the rapid growth of this industry. Convergence between the capital markets and the insurance market has been a long-term strategy of many capital market professionals, as they struggle to demonstrate higher than average yields for their clients. Based on recent growth, many observers believe that 2015 will outperform 2014. For example, A. M. Best is predicting further growth of insurance-linked securities as capital markets attempt to meet the “insatiable appetite of the investor.” However, continued growth of the ILS market is expected to be difficult so it is trying to expand the scope of coverage.

Initially, CAT bonds were generally limited to losses that originated from peak natural risks (hurricanes and earthquakes) in the U.S. More recently, ILS have been utilized in a wide variety of locations and for a number of different risks. Current trends indicate that non-catastrophic risks such as applications in life/annuity and health fronts are starting to be presented to the investment community.

All this activity begs the question, “Will the capital markets remain interested following significant loss activity?” This is the $8.8 billion question. Also of interest is how the capital markets will react to increasing interest rates, which will provide higher yields than are currently available. Despite all the unknowns, investor interest is currently sky high. Many of the new ILS issuances have been oversubscribed and typically done at lower interest rates than projected. It now appears that ILS are here to stay as the lines that separate reinsurance from ILS continue to blur. Change is occurring at a rapid pace and participants on both sides of this issue will need to closely monitor the evolution.

Agents and brokers who have accounts that utilize significant amounts of reinsurance need to be aware of the advancements that are being made in the ILS market. The old days of competing on price are disappearing. Capital market professionals believe it is only a matter of time before reinsurance and ILS will be used in the same manner that reinsurance is purchased in layers today. It will not be uncommon to find excess limit programs that are made up of a combination of reinsurance and ILS. The genie is out of the bottle, and the capital markets appear to be willing to embrace the convergence with the insurance/reinsurance concept. As a result, agents and brokers who are interested in a long-term view of the insurance industry would be well advised to monitor this situation closely as it will remain extremely fluid for some time.