The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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The collateralised reinsurance market has been gaining force over the past year and observers say its momentum is likely to continue after clearing the hurdle of the March earthquake in Japan.

Much of the collateralised market activity is taking place under wraps, in the private segment of the market where non-traditional reinsurers write collateralised reinsurance deals.

Goldman Sachs partner Michael Millette has estimated that this market overtook the public cat bond market in size for the first time in 2010, putting private market capacity at up to $15bn compared to the $13bn outstanding cat bond volume. Industry loss warranty capacity adds a further $3bn to the collateralised market.

Click to enlarge But Millette said private market capacity was set to rise further as retro prices and demand increased. Most business done by the private market is retrocession, as capital market capacity offers reinsurers a solution to the problem of seeking cover from their competitors.

Sidecar investors that came into the sector during the last hard market after Hurricane Katrina were now considering extending capacity again, Millette says. "These investors include many hedge funds, certain private equity funds and some pension funds."

On the buy side, Barclays Capital's head of event-linked products, Daniel Brookman, says there have been "phenomenal" levels of inquiry about collateralised reinsurance from potential first-time buyers, including corporations and governments, after the Japanese earthquake.

"Even if only a fraction of these reach the finish line, the insurance-linked securities (ILS) asset class will have more variety of new regions and perils than it has ever seen before. It's a very exciting time," says Brookman.

However, others were more measured about the potential for growth this year, given that the Japanese earthquake and other loss events have provided the private market's first real test. "It all depends on how much capital becomes free again," says Al Selius, ILS managing director at UBS.

It's difficult to judge how much capital - in the form of collateral secured against the reinsurance contracts - may have been frozen by the recent losses because many providers aren't required to publicly report their losses. There is also debate about the extent of rising retro rates, as noted by Greenlight Re, a capital market provider.

The Cayman Islands-based reinsurer, backed by David Einhorn's hedge fund Greenlight Capital, says it was fortunate in taking only $10mn of quarterly catastrophe losses. President and chief underwriting officer Bart Hedges says he expects that some new private and hedge fund-sponsored retro writers will have experienced severe losses.

"We have significant spare capacity if the market for cat retro hardens, but we have not yet seen solid signs of that happening," he said.

Consequences
Some fear that by chasing higher yields or diversity, the rampaging private market is steering the ILS sector away from its original purpose and potentially threatening its point of difference.

Ontario Teachers' Pension Plan ILS director Philippe Trahan says the genesis of the market was in supplying reinsurance capacity for peak risks, by sitting on top of traditional reinsurance capacity for a low-risk, lower-yielding return.

"It seems to me partly suicidal for the ILS market to behave more like reinsurers, rather than complementing them at the top of reinsurance structures - why are we chasing diversification and yield so aggressively?" Trahan says. There is room for some overlap, he adds, but the ILS market is encroaching more on traditional reinsurers' turf.

Others are more agnostic. Paul Schultz, president of Aon Benfield Securities, says both traditional and collateralised reinsurance capacity will have to keep pace with each other in the terms and features offered. "Alternative markets help keep everything in check. The clients have a choice, that choice tends to keep markets efficient," he says.

Millette argues that the two sides of the ILS market were clearly differentiated, serving different needs. "[The private market] hasn't necessarily been growing as a substitute or at the expense of the bonds," he concludes.