The insurance-linked securities (ILS) market has sprung to life in recent years. Reinsurance and insurance firms have started to accept ILS as a committed source of capital that can provide risk protection at an attractive price. They’re also realizing the economic benefits of diversifying their risk protection portfolios beyond just traditional reinsurance.
In the past decade, ILS has migrated through the insurance value chain in terms of where the capital can be most useful to the industry. Initially, ILS was used predominantly for the reinsurance of high-severity, low probability events known as catastrophe bonds (CAT bonds), which were used to assist with costly natural disasters and other catastrophic events. Since then, the use-cases for ILS have expanded into the wider insurance market, with some insurers now using it to help them take on new risks and expand their product portfolios.
“In the last five years, there’s been additional work to develop tools or facilities whereby ILS capital can be more directly used in the insurance market itself,” said Paschal Brooks, chief operating officer at AlphaCat, an AIG-owned investment advisor that manages capital through ILS and other property, catastrophe and specialty reinsurance investments. “It’s a little bit more complicated to make that additional step because ILS capital is typically used in a collateralized form, which means there’s a finite amount of capital available and there’s a requirement for some type of fronting company or rated paper to be used in between the ILS capital and the insurance buyer.”
To date, the ILS structures used most prominently in the insurance broker space have involved partnering with brokers to find risk originators, such as managing general agents (MGAs), in order to provide ILS capital directly to those portfolios, explained Brooks. In such structures, there’s often a requirement for another party to be involved – typically, a fronting company.
“What we’ve found is that those types of structures often end up being very expensive because there are multiple parties involved in the transaction, and each party wants to receive an equity-type return for the volatility they’re accepting. That’s perfectly reasonable and understandable, but it doesn’t necessarily lead to a great solution in terms of the ultimate return on capital,” Brooks told Insurance Business. “We think there are better opportunities for insurance companies that have an integrated ILS platform because it’s a more efficient way of sourcing a portfolio. Also, because it’s all within a single organization, there’s a better understanding around the ultimate economics, so you don’t have multiple parties trying to extract equity protection around volatile returns.”
Bermuda-based AlphaCat was formed in 2008 as part of the Validus Group. Following AIG’s acquisition of Validus in July 2018, the firm has now become one of the largest ILS managers affiliated with an insurance company. Brooks said AlphaCat is excited and optimistic about working with AIG to develop ILS-backed insurance solutions moving forward. He also expects the insurance-ILS trend to grow in the wider industry moving forwards.
“Subsequently, I think [the development of ILS-backed insurance solutions] should make brokers’ lives somewhat easier in the future,” Brooks added. “Right now, they’re intimately involved in trying to structure these complex arrangements [with MGA fronting companies], but in the future, the hope would be that they can go directly to insurance companies that have integrated ILS capital into their insurance product offering and therefore can gain some advantage in terms of pricing and capacity.”