Empowered Expertise

A sidecar named alternative

by Editor ., . on

Between all the talk about market conditions and London’s future, something important has already flown under the radar in 2018. A number of Lloyd’s managing agencies have launched sidecars funded by insurance linked securities (ILS) capital. In one way they take Lloyd’s back to its roots. In another, these capacity vehicles provide a partial solution to the challenges of market conditions and London’s future. This is the year that ILS vehicles will challenge traditional views about capital at Lloyd’s, and help the market to expand its horizons.

The market for ILS has been very attractive for investors and insurers. Investors are attracted to these contracts because they are unrelated investments the investors normally trade in the financial markets. The union of insurance risks with the capital markets creates a new method for insurers to spread their risk and raise reinsurance capital. These vehicles allow Lloyd’s insurers to secure reinsurance from the capital markets, on a fully collateralised basis, effectively serving as a capital lever and allowing the expansion of their underwriting capacity at what can often be a lower cost of capital than traditional markets.

New ‘Risk Transformation’ tax regulations were formally launched by the UK Treasury in mid-December 2017, following parliamentary scrutiny and heavy market input. This creates the regulatory and supervisory framework necessary to develop ILS industries in the UK. These regulations are designed to make London a more attractive place to do ILS, and they create a significant opportunity for Lloyd’s to get back to a foundational skill: matching capital with risk. Through 2018 and beyond, with the new rules at their back, managing agencies are likely to become more focussed on packaging divergent risks to suit different investors, and better at it, too. In this way, leading companies will find ILS a flexible alternative to class-based and whole-account reinsurance.
The challenges are twofold: bundle risks – from catastrophe to cyber – to suit specific capital providers’ risk appetites and return requirements, and demonstrate how such bundles will meet them. Lloyd’s is central to the development of this industry in allowing access to a variety of investors with variable appetites and expectations, and developing the flexibility to match capital providers with portfolios of risk that suit them, enabling us to price risk more competitively. It was an important skill when all Lloyd’s investors were Names, and it is the way we must work now, to keep pace with the evolution of insurance investment.
Some market colleagues continue to argue that ILS investment is hot money that will flee our sector when its fingers get burned badly, but I believe 2017 disproved that theory. ILS markets perhaps reloaded even faster than conventional reinsurers, and improved their rates. Talk of ‘trapped capital’ barricading the business clammed up quickly. ILS investors are sophisticated, and haven’t missed the fact that catastrophes could wipe out their capital.
True, a model-breaking loss could jolt their confidence, and higher risk-free returns following an interest-rate rise could strip away some funds’ allocations. However, the diversifying nature of insurance risk will always remain as an offset. And after ILS investors’ quick re-load, they may adjust their return expectations upwards, to drive market conditions the same way. They are not immune to caution.
ILS is rapidly becoming another variety of conventional capital, and we should embrace it. Deploying capacity from a mix of sources – whether ILS funds, reinsurers, trade partners, shareholders, or traditional Names, whilst excelling at portfolio creation is likely to be a winning strategy. These factors unite in a new skill base: to marry internal capital modelling with the risk-return appetite of ILS funds, and package risk accordingly. If we all do that well, we can build on our market’s strengths, and secure our profitable future.

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