Hurricane Andrew was the most devastating hurricane in US history. The category 5 hurricane caused 65 deaths, destroyed more than 800 homes and was responsible for $26.5 billion of damage...
Hurricane Andrew was the most devastating hurricane in US history. The category 5 hurricane caused 65 deaths, destroyed more than 800 homes and was responsible for $26.5 billion of damage.
It was the first time that the US had experienced a natural disaster of this magnitude since the post-war economic boom. Home ownership was higher than ever before, and as such insurable losses were massive.
It was against this backdrop that catastrophe-linked capital market instruments first appeared. It was assumed, owing to the unprecedented scale of the disaster, that traditional reinsurance and retrocession capacity would shrink markedly.
Following developments at the Chicago Board of Trade, futures contracts were created with a direct link to catastrophe losses in the US. Within a few years, the first securities were issued on this basis, and these days the industry sees in excess of $15 billion trading between capital market investors.
The market for insurance-linked securities (ILS) was created as a response to large, unpredictable risks, and this has proven to be very attractive to insurers and investors alike.
ILS in Guernsey
The domicile of Guernsey has embraced ILS enthusiastically, due to a combination of factors, according to Robin Fuller, executive director of Dexion Capital.
“We have two of the essential components here. We have a mature captive insurance industry, which gives us a lot of insurance management expertise. We are also a very large fund centre, so it is the coming together of those elements, insurance management expertise together with a large alternative investment industry offering a rich source of capital.”
In December 2013, the EU’s insurance advisory service called for further supervision of the ILS market. The industry has enjoyed tremendous growth, and this has piqued the interest of the regulators from a financial stability standpoint.
According to the European Insurance and Occupational Pensions Authority (EIOPA), the independent body that is a part of the European System of Financial Supervision, ILS issuance has, since 2007, allowed large capital inflows across the insurance industry and helped to increase global reinsurance capital to an all-time high.
EIOPA believes that insurance supervisors should monitor ILS transfers more closely because the instruments could obscure the overall risk transfer picture.
In a statement on financial stability, EIOPA said: “The availability of so much reinsurance capacity creates a strong competitive environment. Developments in ILS also need close monitoring by supervisors as the extensive usage of ILS tends to cloud the picture in terms of understanding the risk transfer.”
Is the level and quality of regulation in Guernsey adequate? Fuller says: “The insurance and investment industry are regulated by the GFSC, and investment vehicles tend to be regulated by its insurance division, or the investment division, or both. The insurance regulator here is very credible, and it sits on the international insurance supervision organisations, just as the investment division is part of IOSCO. Guernsey is very much attuned to international regulations on both the insurance and investment side.”
The Guernsey Financial Services Commission licensed 89 new international insurers during 2013, meaning that there were 758 international insurers licensed in the island by the end of December 2013.
Fiona Le Poidevin, chief executive of Guernsey Finance, says that a significant proportion of the licences issued last year were associated with structures related to ILS.
“It is pleasing to see that Guernsey remains a popular international insurance centre. These figures build on last year’s very strong performance and together mean that nearly 200 international insurance entities have been licensed in the Island during the last 24 months. The increases continue across the different types of entities, although there is particularly strong growth in PCC and ICC cells and especially in relation to ILS structures.”
“Guernsey’s international insurance expertise, our close proximity to both London and Zurich and our access to major global capital markets mean that we are increasingly viewed as a centre of choice for ILS. We are looking to build on this during 2014 through a number of different marketing and promotional activities which will highlight that Guernsey not only has a particularly experienced insurance sector but also a large investment funds community so is able to bring together both sides of the ILS equation.”
The future
The growth of ILS has been phenomenal, and analysts expect it to continue in the year ahead, as investors look for products that are going to meet their increasing demands for income.
Fuller says: “With interest rates and bond yields at a historic low there is a lack of income at the moment. If you look at the investment market and what’s selling, it tends to be anything that’s offering income. Of course, with insurance products investors hope to make a profit at the end of the year which offers distributable income.”
“From an investor’s point of view, ILS is an attractive source of income which is uncorrelated with other asset classes. Much of correlation comes with the way the product is packaged. If you package it as a listed company, and something happens that impacts confidence in the market as a whole, there will be an element of contagion. Correlation comes through in the way the investment is structured, but the returns are largely uncorrelated with other major asset classes.”
One reason for the growing popularity of ILS is that it is universal, which explains its global appeal. Across the world, governments are struggling with shrinking budgets in a slow global economy.
ILS is one way in which an area traditionally financed by governments, catastrophe insurance, can be offloaded into the private sector.
This follows the example created in another area of difficulty for insurers, terrorism. The success of the US government’s Terrorism Risk and Insurance Act programme has left its proponent hoping that it will be extended beyond its current expiry date at the end of 2014.
Slow growth in traditional investments has also contributed to the success of ILS, and market practitioners have taken advantage of the fact. Traders in ILS in 2014 will benefit from years of research, innovation and increased choice in the market.
With a steady increase in third party capital, reinsurers are having to get competitive to bring in business, and this is helping to lower the cost of ILS structures, and to make this relatively new class of security an attractive investment.
While ILS is still very much a niche in the gargantuan securities market, its growth is being watched closely by major industry players, meaning that its significance is only going to increase in the years ahead.
