LONDON (Reuters) - Insurers’ sales of financial instruments to offload natural disaster risks have cut the market share of reinsurance hubs such as Bermuda and Lloyd’s of London by up to 30 percent, experts say.
Investor demand has helped keep catastrophe insurance costs from rising. But that has caused friction between some reinsurers selling disaster insurance and funds that invest in insurance-linked securities (ILS) - transactions that use investor money as backup to pay for any potential reinsurance claims.
The ILS sector was set up in the early 1990s as a way for insurers and reinsurers to manage their exposure to expensive natural disaster risks such as U.S. hurricanes, by passing on the potential losses to investors.
This year, sales of ILS instruments such as catastrophe bonds have grown thanks to attractive returns and the growing perception that they are insulated from mainstream financial and economic shocks.
Investors have pumped another $2 billion via hedge funds into the ILS sector in 2012, after disasters including Japan’s Tohoku earthquake inflicted a $116 billion loss on insurers in 2011, the industry’s second-worst catastrophe year on record.
Reinsurance prices typically jump in the wake of big payouts by the industry as less well-funded players are forced to retrench, leaving those still in the market free to charge more.
But flexible capital instruments such as cat bonds, Industry Loss Warranties (ILWs) and other derivatives have kept costs from rising, squeezing reinsurers’ ability to make profits.
ILS money has curbed industry hopes of a sustained increase in prices, and reinsurers blamed ILS at the summer renewals - when many insurers renegotiate the cost and terms of the annual risk cover they buy from reinsurers.
Rival reinsurance firm Guy Carpenter said ILS money will compromise 20-30 percent of total reinsurance spend.
The trend has particularly hit specialist reinsurers in Bermuda and Lloyd’s of London who have always catered for U.S. property catastrophe risks, a small market which prices well because of the volatile nature of disaster risk.
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In view of the growth in ILS, many reinsurers have set up their own ILS platforms, such as Tokio Millennium Re and Scor, and Munich Re.
Other reinsurers such as Validus Re, Montpelier Re and Renaissance Re have invested in cat bonds and ILS funds, and issued “sidecars” which share the risks of certain policies with the investors in exchange for a portion of the premiums.
“We decided a while ago we wanted to be involved in the ILS asset class as opposed to sitting on the sidelines and watching it happen,” said Jeff Sangster, group chief accounting officer of Bermudan reinsurer Validus Holdings, Ltd.
The ILS market is still small, representing $3-4 billion of premiums in 2012, compared to $18 billion in the global property catastrophe reinsurance market.
But ILS funds say they are creating up to 40 percent of new business, and increasing market share in the areas where natural disasters hit the hardest, such as the U.S., which makes up just over 50 percent of the $18 billion global reinsurance premiums.
“In the Florida market, the ILS sector may actually be the same size as the traditional reinsurance market,” said John Seo, co-founder at ILS fund manager Fermat Capital Management - each of the ILS markets and the traditional reinsurance markets currently writes around $20 billion in risk limits for Florida hurricane risk.
“When it comes to highly concentrated risk like Florida, we tend to charge less and because we have a more efficient capital structure,” he said.
State-backed Florida Citizens caused a stir in April, when it placed a $750 million cat bond rather than seeking traditional reinsurance protection - the biggest ever sold in a single tranche.
This deal caused frustration for many reinsurers, who believed the presence of third party capital resulted in disproportionate rates for the covered risk.
The ILS market could reach a capitalization of $43 billion by 2015 from its current has a size of $33 billion, says Guy Carpenter, pointing to drivers such as regulatory requirements to set aside more capital to write catastrophe risk.
But reinsurers question the durability of fungible capital.
“The ILS market has not been properly tested,” said Bill Pollett, chief corporate development and strategy officer, at Montpellier Re, a Bermudian reinsurer who actively participates in the ILS sector.
“When the big one hits, will they be willing to quickly pay their claims, compared to a reinsurance industry with a long history of timely claims payments?”
Investors could rapidly exit the market if other asset classes’ returns improve, or if the products do not perform as expected after a significant U.S. loss event.
“The key to disclosure is in the term catastrophe bond - no investor is putting money in without some comfort about possibly losing it,” said Seo.
- For more details on cat bond transactions, see the Thomson Reuters Insurance Linked Securities Community, click here. (Editing by Hugh Lawson)