Hiding in Plain Sight – The Unicorn You May Have Missed:
Attend any insurance-focused conference and you will undoubtedly hear about the high volume of angel and venture capital currently chasing the next unicorn in insurance – the industry equivalent of Facebook or Amazon. In the search for value, investors are first asking questions about how long it will take for innovation to transform the industry’s business model or who will be the major disruptors. Is it the new approach to distribution that will render the current ecosystem extinct? Is it a different approach to underwriting courtesy of new advancements in data and analytics? These are legitimate questions – but what if we are looking in all the wrong places? What if the next Uber of insurance has already arrived?
An important component of the value chain in consumer-facing markets is access to the customer. Creating a user-friendly application drives user engagement, and therefore retention. The critical difference in the insurance industry, however, is the lack of engagement. Insurers are challenged with a product that does not lend itself to a frequent interaction with clients. There are typically only two points of contact: sale and claim payment. Though both present opportunities to build customer relationships, this number is orders of magnitude lower than for consumer technology applications. This means insurers need a better solution to work around the value chain to gain control of the customer, one that involves driving down costs. Herein lies an unexpected solution – alternative capital.
Alternative capital refers to pools of capital available for the transfer of risk from an insurer to the capital markets, typically in the form of insurance-linked securities (ILS) or Special Purpose Vehicles (SPVs). The impact of alternative (or third party) capital is well understood in the reinsurance world today as global risks have been packaged, turned into portfolios and offered to the very largest providers of capital in the world as an alternative, risk bearing asset class. The size of the market has grown considerably in recent years, with alternative capacity reaching $86 billion, or 14% of global reinsurance capital, as of the first quarter end of 2017 according to Aon.
Caption: Alternative capital represents 14% of global reinsurance capital.
The question, though, that investors should be asking is who has access to the cheapest cost of capital. The answer to this question, the authors believe, will yield important insights as capital efficiency enables players in this space to get closer to the clients, and more specifically, the source of risk. After providing appropriate scale for disruption in the industry, along with an important framework to understand industry cost of capital, we consider evidence from the banking sector and anecdotal data from current trends in the market to argue that the Uber of insurance is already here.
Disruption at Scale
In an era of rampant overcapacity, it is sometimes easy to forget the historical significance of access to risk-based capital. The explosion of new technology applications to challenge the gatekeepers in the industry, funded by a dramatic rise in venture capital for InsurTech start-ups, has taken a lot of interest among industry participants. Insurance and reinsurance applicants are still, though, fundamentally sending submissions and applications to be accepted as insureds and cedants. It is an offer of risk transfer for premium. Unless platforms that control the customer also start retaining the risk with an equal to or lower cost of capital, the incumbents are still likely to control the system. Until this happens, those who build the best capital platform can offer the best products to attract customers, with the lowest cost capital translating to lower prices for consumers – a reality supported by the scale of alternative capital disruption.
Caption: Alternative capital currently on risk in 2016 dwarfs VC funding in InsurTech
While the scale of InsurTech investment itself is enough to make serious people sit up and take notice, it is the speed, velocity, sources and efficiency of capital that will drive the future direction of the industry. In order to assess the long term impact to the industry of these dueling solutions to disruption, an understanding of the drivers of industry cost of capital is required.
Insurance Company Cost of Capital
While ILS as a practice is nearly 20 years old, we are still in the first inning of how this once niche part of the global reinsurance and risk transfer market will expand its influence. The current problem the industry is facing is that it does not do a good job of differentiating capital sources with specific levels of risk. Investors looking for a 5% or 7% or 11% return all fund risk whether at the 1-in-50 return period or 1-in-250 return period. This capital inefficiency not only lowers margins, but also increases the cost of capital and perpetuates a system that hinders new product development at the expense of the end consumer. The use of third party capital gives underwriters the ability to cede remote, capital-intensive risk off their books and onto a lower cost balance sheet. This matching of different types of risk with different pools of capital produces a leaner, more customer focused, lower-priced risk transfer market, ultimately benefitting the end consumer from cheaper reinsurance products.
The industry also cares about returns. Meeting analyst expectations has become increasingly difficult as pricing and investment yields have declined. Since insurance companies operate in a market that is becoming more commoditized, insurers and reinsurers need to either find another way to increase returns or figure out a way to lower their cost of capital. Alternative capital providers have a fundamental advantage in this respect, as “…pension fund investors are able to accept lower returns for taking Florida hurricane risk than rated reinsurers, for whom the business has a high cost of capital”. Similarly, the opportunity cost of capital for a typical venture capital fund (16.7% before management fees and carried interest) outstrips the hurdle rate for pension fund investors who turn to catastrophe risk as a diversifying source of return.
Similarities to the Banking Sector
The importance of cost of capital in determining winners and losers in capital-intensive industries can be clearly seen in the banking sector. When banks accessed lower cost capital through capital market participants, their balance sheets were essentially disintermediated as they no longer had to finance the bank’s capital charges. By going straight from the issuer to capital and removing the need to finance these expensive capital costs, the aggregate cost of the system (value chain) was reduced. This benefitted consumers and drove retention in the same way we normally associate technology disintermediating distribution in other industries to drive down costs.
Just as loan securitization transformed the banking industry, so too can risk securitization change the economics and value proposition of insurance for the end consumer. Capital disintermediation offers new operating models that connect the structurers of risk with the pricers of risk, until disruptors prove they can do this better. Since insurance underwriters and mortgage loan originators retain differing levels of risk ceded to the capital markets, gaining access to the most efficient forms of financing is an increasingly important battleground for players in the insurance space. When investors no longer tolerate capital inefficiency and increasing returns proves challenging, value chain disruption is a real threat because the lack of client proximity and customer engagement provides no competitive moat. A comparison between the recent growth in U.S. P&C industry direct written premiums and growth in U.S. P&C industry surpluses shows just why capital efficiency is so important.
Caption: Renewed focus on capital efficiency as industry surpluses overtake industry premiums
Industry surpluses have increased at a rate more than double that of industry premiums ($418 billion increase vs. $200 billion increase) since 2002. The surplus growth relative to premiums highlights the steep drop in capital leverage from 1.4 in 2002 to 0.8 in 2016. As insurers sit on larger stockpiles of capital, they are relying less on underwriting leverage to juice up returns in order to meet their cost of capital. Hence, pricing power and cost controls have taken on increased importance.
The Current Fall-out
The growth of alternative capital has fostered innovation, both directly and indirectly, among industry participants across the value chain. Under the weight of efficient capital, industry players can take a step beyond leveraging InsurTech to create value within the system – they can collapse it. In fact, we are seeing this happen right now. ILS funds such as Nephila are bypassing the entire value chain by targeting primary risk directly. Nephila’s Velocity Risk Underwriters insurance platform enables the ILS manager to source risk directly from the ultimate buyer of insurance. From consumer to agent to the Nephila plumbing system, homeowners’ risk in Florida can be funded directly by a pension fund in another part of the world.
Innovation is a healthy response and this evolution of the reinsurance business model, while producing losers, will produce a leaner, more customer focused, lower-priced risk transfer market in the end, ultimately benefiting everyone. The opportunity set for alternative capital to benefit the industry is not just limited to retrocession and access to efficient capital. Leveraging third party capital to provide better products and services to clients allows insurance companies to not only expand their current product offerings, but also extend the value proposition beyond price alone, with different capital sources offering different structural product designs, terms, durations, and levels of collaterization. As an example, consider solar. The InsurTech solution to creating a product that will provide protection for this emerging risk might include distribution and analytics. In contrast, partnering with third party capital providers can allow an insurance company to create a product with unique features such as parametric triggers that could solve a problem the traditional reinsurance industry, with its complicated and long casualty forms, has long struggled with. In doing so, third party capital can help grow the market for insurance in a way InsurTech has not yet achieved.
Two of the most common counter arguments for alternative capital’s Uber-like impact on the industry are that it remains largely untested capital in the face of a significant event and that we’ve hit a ceiling on the limit of third party capital in the traditional reinsurance market. On the first point, as of this writing, it is still too early to assess how existing and new potential third party capital investors will respond to hurricanes Harvey and Irma in upcoming renewals. However, the combination of the ILS market’s established track record, experience paying claims, and fund managers staffed by people who have long experience as reinsurers provides support that investor interest post-event will remain strong. As for the second, in a static world, that claim may be true. But we believe there is plenty of room to grow in this market from both a supply and demand perspective. On the supply side, ILS accounts for only 0.6% of the global alternative investments market, with ample room to increase assets under management according to the latest survey on alternative assets from Willis Towers Watson. On the demand side, around 70% of global natural catastrophe losses remain uninsured, and these risks are only growing. Insurers will require protection against aggregation and accumulation risk, and increasingly see the natural home for the tail risk in the capital markets and ILS.
We have witnessed alternative capital’s ability to attract risk to capital and lower aggregate cost of the entire value chain. Many in the industry are monitoring how InsurTech will sustainably attract risk and attract customers over the long term. In the meantime, the companies that have used their time wisely in the soft market by increasing capital efficiency to source, return and attract new forms of capital the quickest will be well positioned in the space and can happily partner with great distribution partners of their choice. Even so, the players with the lowest cost of capital can accept risk quicker, easier and can develop products cheaper and with unique technological features for consumers.
InsurTech will still play a pivotal role in shaping the future of the industry. Most of the participants in the InsurTech space are in the early stages of capital formation. As investment scales and business models mature, InsurTech should help leverage the proliferation of new sources of information and data pools to advance the securitization of different types of risk. Access to enhanced analytics helps make the underwriting and funding of more intangible risks, such as reputation and contingent business interruption, more sustainable, thereby increasing the participation of third party capital in lines of business outside property catastrophe.
In the mid-1990s, far less than 1% of global reinsurance capacity comprised alternative capital; by 2016, its influence had grown to nearly 15%. Here is our question for the next industry conference: what will alternative capital look like in 2030?
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Expect ILS sector to be larger post-event: Paul Schultz, Aon Securities
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