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Slow return to normal: ILS Market Update Q2 2019

Insurance Linked Securities|Reinsurance
Insurer Solutions

August 7, 2019

Reinsurance is viewed as a relationship business, and capital markets are viewed as purely transactional. Reality tells a different story.

It is often said to the point of being a cliché (and especially at industry conferences around the world) that reinsurance is a relationship business and, as a counterpoint, that the capital markets are purely transactional. Reality, especially as reflected in the 2019 market, has more nuance. Relationship behaviour is not the exclusive domain of reinsurers, and neither is transactional behaviour exclusive to investors.

Costs and benefits

Some of the benefits of a strong two-way relationship seem relatively obvious. For example, a counterparty may participate on one line of business or layer where it might not meet their return targets - with the expectation they will make money elsewhere with the same cedant.

Familiarity also makes it easier for both sides to adapt to changes in the underlying business.

A cedant can better explain important tweaks in their underwriting process if the counterparty knows how that particular cedant selected risks in the past.

A transactional approach also has benefits. Capacity can come in and fill out layers and programs as needed. This additional transactional capacity can lower rates and improve market security as well as terms and conditions via traditional reinsurers and capital markets investors who seize the opportunity to compete and participate for business priced at market.

The renewal process where reinsurers have de facto renewal rights has a substantial cost, even if many like to pretend otherwise. If the program is locked up like Fort Knox, cedants may never know what they are missing. The corollary is that investors who have shunned relationship building and only deploy capital with the best opportunities on offer miss out on the higher risk-adjusted premiums hiding within the walls of Fort Knox because they never see them.

Relationships in H1 2019

In H1 2019, relationships added real value to cedants. In many cases, programs got done at 4/1, 6/1 and 7/1 without the same level of ILS participation as in the past.

In H1 2019, relationships added real value to cedants. In many cases, programs got done at 4/1, 6/1 and 7/1 without the same level of ILS participation as in the past. Companies with multiyear capacity and with breadth in their traditional reinsurance partners and ILS investors did well. They did even better if they had some diversity in how they interacted with investors and reinsurers between traditional quota shares, syndicated XOL reinsurance and cat bond-backed layers.

In contrast, cedants who had few relationships, all single-year capacity and too high a component of purely transactional capacity tended to suffer a little. The key was that the more relationship-oriented investors and reinsurers were relatively reluctant to let go of programs and partners they had worked hard to court, even if pricing, terms and conditions did not meet their wish list or what was on offer from alternative places to deploy capacity.

Lessons learned or mislearned?

While things are slowly returning to a more normal environment on the ILS side, relationships will still matter a great deal in H2 2019 in cedants getting the protection they need with pricing, terms and conditions that make sense.

It only takes one large California earthquake or 100-year return period pandemic with associated impairments to shift the view on credit risk, which currently seems “out of sight, out of mind.”

The risk is that cedants and the broader market read too much into 2019 on this count. The next market inflection point will not necessarily look like 2019. To take one example, in 2019 impairments among relationship partners have been a non-issue. It only takes one large California earthquake or 100-year return period pandemic with associated impairments to shift the view on credit risk, which currently seems “out of sight, out of mind.”

Another approach would be to focus less on the relationships versus transactional partner dimension and more on the breadth of relationships. Cedants should not just work with four insurers and three investors. ILS investors should not source business from just one intermediary. Breadth is going to be the best approach for most people. It does require a lot of work. Sometimes courting an investor with $150 million of assets under management (AuM) seems unrewarding, but then again that same investor could have $2 billion of AuM in due course.

Independently of the breadth of relationships, cedants need to find the appropriate balance between relationship and transactional capacity that meets their own objectives. Some might want a 100% relationship approach with a small number of trading partners, even though doing so has a higher price in increased costs and increased volatility some of the time. Other cedants might accept a large purely transactional component to save money in most years, even though it adds volatility some of the time. The key is to take the time to do this assessment now and then act accordingly with purpose.

Intermediaries have an important role here in helping cedants strike the right balance. We can then both implement the approach in program design and help build the right relationships. All of this is at the core of what we do both in the reinsurance markets and equally in the capital markets. 2019 gives us the opportunity to do even more of this so our clients can succeed in 2020 and beyond.

If you have any questions or comments, please reach out to any of the contacts listed below.

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