Academics Praise ILS Market Fundamentals but Raise Some Caution
2 min read

Academics Praise ILS Market Fundamentals but Raise Some Caution

The following is a preview coverage of the IQPC Insurance Linked Securities Summit held in New York last week. Other stories will be available to premium news subscribers.

The stage is set for growth in insurance linked securities, but how the market addresses some fundamental structural issues will determine when and by how much, researchers argue.

Changes in the capital structure of the reinsurance industry are slowly moving in favor of capital markets structures, said Kenneth Froot, professor of business administration at the Harvard Business School during a keynote address at IQPC Insurance Linked Securities Summit last week.

Froot, the author of The Financing of Catastrophe Risk, said his research shows that capital for traditional reinsurers is slowly being drained by large “catastrophe risk shocks” like Hurricane Katrina and the September 11 terrorist attacks.

Each time the reinsurance industry has its capital base “depleted” by a catastrophic event, Froot argues it costs the industry significantly more to replace that capital. The resulting pressure and the inability to raise prices quickly is pressuring reinsurance balance sheets.

“Every dollar in reduction of capital adds up to more than a dollar in market capitalization,” Froot said. “Every dollar of surplus adds to market value, but every time you lose a dollar in surplus you lose more because your market value has begun to fall and you become distressed.”

Additionally, the financial crisis that started in 2008 will likely push regulators to tax large conglomerates like reinsurance companies.

“We know that ILS is still only a small piece of the puzzle and the bulk of the exposures are warehoused with reinsurers and insurers,” Froot said. “However, the economic crisis is pushing us away from intermediation and the role it will play in developed financial systems.”

Froot cautioned that although traditional reinsurance may play a smaller role in risk transfer over the next several years, ILS structures like catastrophe bonds and collateralized reinsurance need to continue to evolve. He cited individual transaction costs, structural problems and transparency issues that need to be worked out for the industry to thrive.

“There has ben underlying friction and troubles that have held back the industry even though we had the technology to do this,” he said.

Mortality Shock

Despite several academic studies arguing for increased longevity, the life securitization industry needs to prepare for a possible spike in mortality within the insured population, said Jay Olshansky, Ph.D., professor of epidemiology at the University of Illinois at Chicago.

“There is an incredible amount of evidence to suggest that subgroups of the population — including subgroups that you are particularly concerned about — are going to die much earlier than is current anticipated,” Olshansky said during his presentation at the IQPC conference.

Olshansky explained that although technical logical advances will increase longevity in the broader population, a dramatic rise in obesity in the United States will likely lead to increased mortality.

“Obesity has swept across the United States and the evidence is definitive that several attributes of mortality are linked to obesity,” Olshansky said.

The dynamics of the insured U.S. population that includes access to health care and better education is fundamentally different than any other subgroup of the population and could mitigate a percentage of the mortality rate, Olshansky said.

However, the researcher added that those dynamics will not always overcome the role that obesity plays in mortality.

“I would be cautious because these subgroups of the population carry very unique mortality dynamics,” Olshansky said. “I would caution using standard life tables, because they don’t really apply.”

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