In its latest report on the financial stability of the continent's insurance and pensions industry, (available here) the European Insurance and Occupational Pensions Authority (EIOPA) has expressed the need for close regulatory scrutiny of the insurance-linked securities (ILS) market to ensure it does not threaten the (re)insurance sector's financial stability. It highlighted the largest threats for European insurers as low interest rates, stunted economic growth and exposure to unstable government bonds.
These threats have steered pension and hedge funds towards ILS, which act as an alternative to traditional reinsurance with an attractive risk/return profile. ILS depend on the occurrence (or lack of occurrence) of infrequent events such as earthquakes and hurricanes.
Reuters has reported that the issuance of new catastrophe bonds (a form of ILS) is set to hit nearly $7bn in 2013, according to Swiss Re. Whilst Aon Benfield estimates that a total of $44bn is deployed in the ILS market as a whole, and predicts a further $100bn input over the next five years.
EIOPA expressed concern at this increase, particularly for investors which do not have the ability to analyse the risks and complexity of the insurance market. It stressed that insurers must diversify assets to protect policyholders. It said that "Otherwise, policy holders may end up with insufficient protection which could ultimately impair their willingness to enter into long-term contracts".
The report stated that the insurance market’s extensive usage of ILS tends to “cloud the picture in terms of understanding the risk transfer” and is creating “a strong competitive environment” for reinsurers. Similar concerns were expressed by the Prudential Regulation Authority (PRA) in September, with the worry that traditional reinsurers might take on risk too cheaply to try to compete with the flourishing ILS sector. For commentary on the PRA’s approach to alternative capital in the reinsurance market, click here.
EIOPA also noted that overall liquidity risks are increasing but remain a non-critical risk. EU insurers and pension funds are known to be active counterparties to swaps relating to longevity and mortality risks. However, there was an overall decrease in the use of liquidity swaps, implying that some insurers are keeping more liquid assets on their own books.