Ben Canagaretna examines how Lloyd’s London Bridge initiative could revitalise the market.
The flux capacitor is the component of the DeLorean car which, at precisely 88 mph, makes time travel possible. London Bridge, a protected cell company created by Lloyd’s earlier this year, is the component of insurance investment set to put Lloyd’s back at the forefront of structural innovation.
Institutional investment capital with a taste for non-correlating insurance risk has long been limited to highly modelled catastrophe risk acquired through catastrophe bonds and collateralised layers. Any greater spread came only through a handful of experimental instruments, or through illiquid and difficult-to-establish sidecars. Now there’s a new alternative, one which could be a game-changer.
Roughly $100bn is invested in insurance through ILS, the bulk of it by institutional investment funds. It’s a tiny amount. According to the OECD, pension funds worldwide held more than $35trn at the end of 2020, alongside substantially more institutional investment from sovereign wealth funds and family offices. That means ILS currently reflects less than 0.3 percent of institutional investors’ capital base.
It is almost entirely deployed against property catastrophe risks, where there’s little room left to grow. However, if liquid instruments are introduced to extend the types of insurance risks available to invest in comfortably, pension funds’ enormous capital could be used to underpin much more of the $5.8trn spent globally each year on non-life insurance. Given the right access, it’s not unreasonable to think pension fund investment in insurance risk will increase 10x over the next 10 years, to 3 percent of their total capital.
In the interim, ILS is booming. New issuance reached record-high levels in the first six months of the year, despite relatively low cat bond prices. That signals increasing institutional demand for insurance risk. We expect considerably more of that money to seek access to what is already a distinct asset class. To satisfy that demand, institutional capital – which is already taking equity positions in brokers, risk carriers and MGAs – will have to move into niche and specialty lines of risk.
Lloyd’s has provided an ideal mechanism to do so. London Bridge Risk PCC, the transformer investment vehicle established by Lloyd’s earlier this year, gives investors access to pure insurance risk underwritten in the increasingly tightly controlled Lloyd’s market. Investors issue fully collateralised quota-share reinsurance contracts. The collateral acts as up to 100 percent of a corporate member’s Funds at Lloyd’s, an amount measured to cover a 1-in-200-year outcome plus 35 percent.
These members – let’s call them SPMs – may be created expressly for the purpose of each transaction, and can be owned by an orphan trust. No individual UK regulatory approval is required, and no additional restrictions are placed on the classes of business covered. London Bridge therefore makes participation in the market very much simpler. And Lloyd’s is attractive, for three principal reasons:
- Reinsurance to close gives investors a pre-defined exit.
- International licences give access to a significant share of the $5.8trn.
- The chain of security provides embedded tail-risk protection and a capital-efficient model that ensures sufficiently attractive returns on investors’ capital.
For this exciting new model to be successful, current market players (rather than potential investors) will need to correct some common misunderstandings. Carriers and brokers often fall into the trap of believing capital markets investors proffer naïve capital. This is entirely untrue. Many pension funds constitute extremely sophisticated investors, often in possession of a much more comprehensive view of risk than some traditional insurance risk carriers. Second, funds aren’t always looking for fixed returns on capital. Instead they tend to focus more than widely credited on risk-adjusted returns, allowing consistent comparisons between investment strategies.
Their investments must match their subtly unique mandates, so specialty lines insurers wooing institutional capital through London Bridge must in turn be more subtle and nuanced in their proposals to investors. With the correct approach based on solid knowledge of both sides of the transaction, billions of dollars in fresh capital pools with an array of return expectations could soon be revitalising the evolving Lloyd’s market, putting it back at the forefront of structural innovation.