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8,000 6,000 4,000 2,000

But perhaps more significant has been the movement of the ILS funds into the collateralised reinsurance market in search of higher returns.

Although cat bond supply has picked up over 2009 and 2010, most

ILS investors now look to a parallel participation in private collateralised reinsurance transactions as a means of obtaining exposure additional to that supplied into the cat bond market, albeit in illiquid form. The cat bond and collateralised reinsurance investor bases are now deeply entwined. Today, collateralised reinsurance is well established as a primary constituent of the retrocessional markets (both ILW and UNL) and is estimated to provide in the region of $7.5 billion of capacity to the sector. Business entering this market is generally high rate on line, bespoke and for lesser individual limits of cover than seen in the cat bond sector.

Many ILS funds have established in-house reinsurance companies Source: Willis Capital Markets & Advisory It is notable that re/insurance brokers have played a more prominent

role in arranging and underwriting cat bonds in the last year, participating in all of the 2010 deals (ignoring self-placed transactions). This is perhaps understandable. Re/insurance brokers typically have a greater insight into their clients’ underlying insurance businesses and risk transfer requirements, and are ideally placed to assess the value to the client of capital markets products relative to traditional reinsurance products and to integrate the two as necessary. Furthermore, we now have an investor market that is well known, specialist and established, so the argument that an investment bank is necessary to achieve full distribution of the securities has been somewhat negated—in practice, the efforts put in by the ILS funds to seek out new sources of capital have proven the most effective means of widening distribution.

In order to attract financing, the ILS funds need to achieve returns on capital that are attractive relative to other investment opportunities in the broader financial markets. A consequence of this search for return, and the scarcity of leverage, is that the average expected loss of cat bond transactions has eased upwards.


15% 36% 47%

0% - 1% 1% - 2.5% 2.5% - 5% 5%

to facilitate the acceptance of collateralised reinsurance, while others have chosen to enter into fronting arrangements with established, rated reinsurers or utilise dedicated segregated account companies to effect the transformation. In practice, these arrangements are enabling ILS capacity to be readily accessed in a recognisable reinsurance (as opposed to capital markets) form, with the consequence that the distribution of these products is now also dominated by reinsurance brokers.

The scope and pricing of the cover that the ILS market can offer

is ultimately a function of the return investors need to support fully collateralised positions. The difficulty that arises is that the main investors in the class (the ILS funds) also need to achieve diversification within their ILS investment portfolio—no ILS fund manager wishes to have all its eggs in one basket. Many investors are now close to full of US hurricane risk and are desperately seeking other exposures to balance their portfolios. The difficulty they face is a traditional re/insurance market benefiting from a surplus of capital and capacity, which can diversify risk more efficiently and thus offer cover at rates on line well below those necessary to an investor.

In sum, one can think of ILS capacity and reinsurance capacity as either

overlapping or truly independent and incremental, depending on the risk. The reality is that the ILS sector today is fundamentally restricted to being an important additional source of capacity in specialist areas of US property catastrophe risk transfer and retrocessional business (where sufficient returns can be generated to support the nature of the capital behind it). There are signs that the product will become more in demand in other areas—for instance, Solvency II is likely to lead to increased demand for catastrophe risk transfer, and a greater focus on credit quality and the diversification of sources of risk transfer. But real breakout is only likely with a fundamental change in the nature and aspirations of the capital supporting the sector, which in current financial market conditions, is not foreseeable in the near term.

Source: Willis Capital Markets & Advisory

Richard Godfrey is executive director at Willis Capital Markets. He can be contacted at:

November 2010 | INTELLIGENT INSURER | 41

European wind US wind US quake Japan quake Japan wind Other WW perils

Total at risk (USDm)

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