ILS Products Are Changing Reinsurance Industry Norms: ‘Acts of God’ Author

By | July 1, 2015

Second of two articles
In the first article in this series, Paula Jarzabkowski, professor of Strategic Management at Cass Business School, City University London, discussed the findings of her book on the reinsurance industry, which show that the market is moving from coverage of acts of God to one that covers commoditized risks. This second article discusses the growth of insurance linked securities, a major force in the commoditization of risks — and one that is changing industry norms.

From their inception in the early 1990s, alternative risk transfer (ART) products now have found a permanent foothold in the market, representing 10 percent of reinsurance premiums, said Jarzabkowski in a recent presentation to discuss the findings of her book “Making a Market for Acts of God: The practice of risk-trading in the global reinsurance industry.”

During their three-year research on the book, Jarzabkowski and her co-authors Rebecca Bednarek and Paul Spee observed 22 global reinsurers, three large brokers and 35 insurers, which ranged from small companies in emerging markets to some of the largest multinationals. They discovered a reinsurance market that has worked extremely well over the years but is beginning to evolve into a commodity market.

A major trend they found is the rapid growth of the ART market — products that were originally developed in 1992 in answer to the hard market that developed after Hurricane Andrew when “insurers were desperate for some capital,” Jarzabkowski recalled.

Market cycles have provided an efficient mechanism for payment after large losses but “we don’t yet know if lowest cost provider pays.”

Since 2012, ART products, now more commonly referred to as insurance linked securities (ILS), have been growing in leaps and bounds, without even a glimmer of a hard market, she indicated at the launch of her book last month at the Cass Business School in London. (Her comments on the other trends affecting the market can be found in the first article in this series).

Diversification of Capital

The good message about these commoditized products is that they help diversify the pool of capital, she said.

In addition, pension and hedge funds, which support ILS products, are putting only a small percentage of their entire portfolio in these products. Since these reinsurance risks don’t correlate with their industry, the chances are high that they will be solvent after a loss, she explained.

Because the ILS products are collateralized with the money sitting in a special purpose vehicle, “we can assume that if a loss happens and it’s triggered, it’s sitting there waiting to pay.”

Another advantage is that the cost of these products is relatively low in the current marketplace, which widens the pool of insured parties, she said, noting that developing countries can now afford to buy ILS products.

Changing Industry Norms

Despite these advantages, Jarzabkowski warned that the growth of the alternative market, with its commoditized products, is changing industry norms.

For a start, she explained, ILS products are generally very narrow and specify a particular type of risk characteristic that will trigger the coverage. “If you can accurately measure exactly what your risk is, then this will be a very good product for you…. They’re very good products if you hit the bulls-eye.”

But, if the ILS product does not hit the bulls-eye with its precise risk parameters, the reinsurance buyer could find that the coverage is not triggered, she indicated.

Jarzabkowski cited an example of the 2011 earthquake off the Pacific coast of Tōhoku in Japan. While there were catastrophe bonds in place, they were only developed to cover an earthquake in Tokyo and therefore didn’t pay for the 2011 damages. The bonds weren’t triggered because they didn’t cover the area where the disaster happened.

On the other hand, traditional reinsurance is more flexible in that it covers a wider range of risks, she affirmed.

Another issue with the ILS market is that it does not create an incentive for relationship-based trading because it is a collateralized product and the buyer doesn’t know the investors behind the product. In the traditional reinsurance industry, relationships between buyers and sellers, over the long term, through multiple cycles, has been the key to its stability and capital flow, Jarzabkowski went on to say.

Will Lowest Cost Provider Pay?

“What is the future of trading in reinsurance in large-scale risk?” she questioned. “I’m not saying these [trends] are bad, but we need to work out what are the new norms and how we can be sure we have good, effective markets that provide cover for your risks when you have a problem,” she emphasized.

Jarzabkowski went on to discuss some of the implications of these trends for the reinsurance industry.

With the advent of ILS products, the market is moving from coverage of uncertain risks to a one where risks are specified and precise, she commented.

“We’re going from a mutual game where insurers and reinsurers have a reason to look after each other and trade through the cycle, to a transactional game.”

Also, the ILS commodity product is lower in cost, which is ostensibly good for insurance buyers, but it also puts downward pricing pressure on reinsurers, reducing their revenue and making reinsurance itself more cost and price focused, she noted.

In addition, Jarzabkowski said, there is no incentive for post-loss payback, an historical characteristic of the traditional reinsurance market, and no incentive for fast claims settlement from reinsurers seeking post-loss payback.

Market cycles have provided an efficient mechanism for payment after large losses but “we don’t yet know if lowest cost provider pays,” she said.

“We’re going from a mutual game where insurers and reinsurers have a reason to look after each other and trade through the cycle, to a transactional game.”

The reinsurance industry is moving toward commoditized risks, which “are measurable, tradable and very sanitized.”

The purpose of the reinsurance industry is to ensure payment in times of loss, she went on to say, explaining that the underlying risk remains the same, no matter what product is in place to provide cover when large losses inevitably occur.

While we assume this risk can be sanitized, we are “still dealing with acts of God – unpredictable, uncertain and often severe.”

A version of this article first appeared in Insurance Journal’s sister publication, Carrier Management, both part of the Wells Media Group.

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