How alternative capital is driving innovation in risk finance

The last two decades have seen the emergence of new structures by which insurance risk can be securitized and transferred to the capital – from catastrophe bonds (CAT bonds) to ILS. While some say that capital under management in ILS funds is as high as $US150b, it still represents a small portion of the industry in which insurance gross written premiums globally stood at an estimated $4.8t in 2017.  

Expanding options for (re)insurers

The most significant impact of alternative capital has been additional capacity in the reinsurance market, resulting in increased competition. Insurers and reinsurers can now tap into different sources of capacity for different risks, and ILS provide them an attractive alternative option for laying off risk.

New asset classes for investors 

For investors, ILS remain attractive. They offer high-risk adjusted returns relative to other fixed-income assets – while increasing portfolio diversification by adding risks uncorrelated to traditional asset classes. However, if alternative capital begins to cover perils that correlate with developments within the financial markets, appetite for ILS may lessen. 

The 2017-2018 impact 

IGLN participants suggested that major losses of these two years would dampen the alternative capital market. Despite the costly economic loss, the overall amount of capital in ILS funds increased. They noted that the importance of investor education in avoiding surprises such as unexpected economic losses from weather-related events. 

Proponents suggest that alternative capital can fundamentally transform the insurance-reinsurance value chain by providing a more direct connection between insurance risk and capital. Others question whether the frictional costs of ILS and alternative capital are greater or less than in the traditional insurance model. IGLN participants discussed potential sources of growth and challenges that impede further development, including:

• Covering new perils and closing insurance gaps. Certain risks are more conducive to securitization and transfer to capital markets than others. Cyber risk is a good example; however, uncertainty about how to model and price this risk raises challenges for investors.
• Trading insurance risk. Introducing secondary market liquidity and a mechanism for price discovery on different insurance risks could make difficult-to-model risks more viable for transfer to capital markets. A marketplace for trading insurance risk – though very much in the early stages – could provide a solution. 
• Shifting to originate-to-distribute raises concerns. The growth of alternative capital, combined with a marketplace for secondary trading of risk, could drive the creation of new business models. As one participant said: “Insurers could become originators and distributors of risk, rather than buyers and holders of risk.” This potential shift toward an originate-to-distribute business model raises concerns about systemic risks analogous to those created by widespread securitization of mortgages in the run-up to the financial crisis.
• Obstacles to growth. The primary factor limiting growth of the alternative capital market is a shortage of attractively priced and appropriately packaged risk – rather than a shortage of capital. The lack of robust models for new perils, such as cyber risk, presents an obstacle for covering those risks. 

Whatever its scope and scale, it’s clear that alternative capital will remain an important mechanism for risk transfer in the future. Vast amounts of capital exist that could potentially be deployed to cover insurance risk. Insurers need to take advantage of the anticipated future growth of alternative capital – even though the current scale is modest relative to the overall insurance market.

In fact, participants agree that the market will continue to be robust – as long as returns are attractive. Insurance-linked investments are subject to the same dynamics as any other investment and need to generate returns high enough to justify the risks.

This article is based on the Viewpoints from the recent meetings of the Insurance Governance Leadership Network and aims to capture the essence of network discussions and associated research.