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State of the ART market

Capital market funding of large and unpredictable risks eases strain on traditional market

 

By Michael J. Moody, MBA, ARM


Over the past few years, Rough Notes has published several articles regarding the state of the alternative risk transfer (ART) market. Overall, there has been significant activity within the ART market; and acceptance of the various methods appears to be gaining traction among buyers, even during the soft insurance market. Roadblocks that have previously been an issue for many buyers have either been removed or another approach has been found to resolve most outstanding issues. As a result, growth of most ART methods has accelerated over the past few years.

A good case in point is captive insurance companies. With increasing frequency, captives have become the standard method for corporate insurance buyers to purchase their property and casualty insurance coverage. Acceptance within the insurance community has also helped hasten the growth of captives. Significant growth has been well documented within the middle market sectors as both the insured and the agent/broker have gained a better understanding of the advantages of the ART market.

After years of trying to find a cost-efficient method of accessing the capital markets, insurance-linked securities (ILS) appear to have also resolved a number of problematic issues. For reinsurers, ILS represents a major change in how they fund several high-risk perils. Among the areas that are receiving significant attention are:

Climate change—Climate change and its effect on the world weather picture are staggering to say the least. According to recent studies, such as the Intergovernmental Panel on Climate Change's Fifth Assessment Report, "with 95% certainty, mankind is causing climate change," and the report goes on to say, "We would be foolish not to listen." The report makes clear that "the transition to a low-carbon economy and more climate-resilient society cannot be thought of as an option; they are necessities."

While there may still be some doubters about the existence of climate change, it can no longer be ignored. Even the U.S. Congress recently passed a bill that acknowledged that sea levels are rising—ergo, climate change is happening. One has to look diligently to find the actual reference because the statement is buried near the end of a 584-page transportation funding bill. And it refers to how exactly the Federal Emergency Management Agency (FEMA) has been using "the best available climate science" to figure out how the flood insurance program should handle rising seas. FEMA estimates that sea levels will rise an average of four feet by 2100, thus increasing by 45% the portion of the country at a high risk of flooding. Additionally these areas will double the number of Americans who will live in the high-risk regions.

Most of these climate-related changes will also undoubtedly result in higher claims levels, and many experts believe that ILS may be just the source of capital that the industry will require. As reinsurers begin to expand the scope of risks they write as well as the emerging opportunities associated with entry into new geographic areas, the capital markets may well hold the key to allow further expansion.

Life insurance—The life insurance market is another area that has benefited from the use of ILS. Starting with what the life insurance industry has categorized as "redundant reserves," it has taken full advantage of ILS. Since about 2000, the regulators have required life insurers to quickly amass large amounts of additional reserves. While the industry was opposed to the higher reserves, stating they were "overly conservative," they have met the letter of the law (Regulation XXX and AXXX) by forming special-purpose captives as a method of compliance. Not only were the captives formed in compliance with the law, many were also funded with ILS. Overall, ILS has proved to provide the strategic approach that XXX and AXXX required.

However, the life insurance industry faces several other potential issues involving catastrophic risk. To fund certain catastrophic events, the industry has developed mortality bonds to back the exposure to natural catastrophes or pandemics where loss of life is higher than traditional mortality projections. Additionally, life insurers face longevity risks—which are the flip side of mortality risks—when annuity payments continue for a longer time than projected. Capital market investors are quite familiar with the traditional mortality tables and thereby have a better understanding of the underlying risk.

Case for capital markets

The recently concluded international reinsurance meetings provided some new insights into why the investing public has been so interested and eager to get involved in ILS. Frank Majors, co-founder of Nephila Capital, said the current industry trends represent an innovation within the reinsurance and capital markets and that it is here to stay. "We at Nephila," he continued, "believe very strongly that what you're seeing is based on some very strong fundamentals that are just economic truths that are not going to go away." Majors described Nephila's investor base of more than 100 institutional investors as "big investors who do a lot of due diligence and understand the asset class and opportunity a lot better than many commentators would have you believe."

Many industry professionals like Majors believe that alternative capital does enjoy a sustainable price advantage over the traditional reinsurance companies that need to be aware of their balance sheets in "peak risk" areas like earthquakes and hurricanes. That's because alternative capital is uncorrelated to securities prices and, as a result, the cost of capital is just lower for peak risks. Accordingly, Majors said this important concept is based primarily on fundamental financial principles. As a result, the institutional investors who participate in ILS and reinsurance as an asset class generally find a lower return with less correlation to be more valuable as an investment than a higher return asset that is more correlated. For these types of investors, ILS and reinsurance-linked investments have a higher value than many other alternative asset classes that may, in fact, have a higher yield.

At the end of the day, "these factors explain the lower cost of alternative capital and they also mean more abundant capital." Additionally, he indicated that "with these attributes, an asset class appeals to a large base of institutional investors, which means scale but also means durability as well." Majors said: "Alternative capital going into the risk in a direct form, in an uncorrelated form and in a clean form, is here to stay." Ultimately, the capital markets should provide access to capital, regardless of the financial results within the insurance industry, because it will represent such a small portion of the institutional investments.

Conclusion

At this point, it is clear that the capital markets will continue to have a role to play and, in all likelihood, an expanding role should some catastrophic event take place near term. In the long term, movement by the capital markets should smooth out some of the peaks and valleys that the insurance industry is famous for. It should provide the insurance industry with the ability to take advantage of opportunities in emerging markets and risks that are bound to come forward. The future use of ART mechanisms should be assured for some time, offering insureds broad coverage at competitive rates.

   

 

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