The fast-growing insurance-linked securities (ILS) market is still in its early days of development and 2014 will provide some clues about its future impact on traditional reinsurers.

That is the view of Steve Evans, a leading observer of the ILS market, who owns the Artemis.bm website, which has been tracking the latest news in alternative risk transfer, including the issuance of new catastrophe bonds, since 1999.

Mr Evans notes that there has been global issuance of more than $7.2 billion of ILS during 2013. Much of that new business has been done in Bermuda, which has emerged as the world-leading jurisdiction in the sector. The news last week of the $75 million Queen City Re Ltd cat bond issuance, sponsored by American Modern Insurance Group, a US subsidiary of German reinsurance giant Munich Re, took the value of ILS listings on the Bermuda Stock Exchange up to $9.29 billion.

Catastrophe bonds are claiming an ever-increasing share of the property-catastrophe reinsurance market — around 15 percent according to some analysts — dampening reinsurance prices for certain perils.

Mr Evans told The Royal Gazette that many reinsurers have embraced the new capital, through the creation of vehicles such as sidecars to utilise it and increasingly through forming divisions to manage and gain fee income from third-party capital.

ILS, as purpose-built structures, offered a cheaper cost of capital than reinsurance companies, which had company expenses and the cost of keeping their shareholders happy to deal with, Mr Evans said.

“Most of the reinsurers in Bermuda have been embracing alternative capital for some time — but that’s not to say they won’t end up being harmed by it,” Mr Evans said.

“It’s very early days and, in my opinion, there are a number of years to go before it’s fully developed. It’s going to be some time before we understand the full ramifications.”

He added that the third-quarter earnings next year might hold some clues, particularly as to whether there were any signs of reinsurers pricing risk too cheaply to hang on to market share.

“For me, 2013 was about the market growing up,” Mr Evans said. Growth had been strong, but sustainable, he explained.

“With so much investment demand, you could easily have seen people doing deals just to get the money invested. That hasn’t been happening. The important thing is making sure the capital is matched with the right opportunities.”

Alternative risk was becoming a more widely accepted asset class, as institutional investors and pension funds increasingly allocated a small portion of their portfolio to it. ILS were now more frequently discussed at major investment conferences, Mr Evans said.

Investors are seeking greater diversification in the ILS market. A just-released report by ratings agency Fitch shows that some 72 percent of the market comprises US wind risks.

However, Mr Evans sees evidence of geographical diversification, with recent issuances including coverage for Turkish earthquake, Australia cyclone, Caribbean windstorm, Dutch windstorm and French windstorm.

The big question over the future of the ILS market relates to the “stickiness” of the capital, in the event of a major catastrophe that triggers cat bonds and wipes out investors’ capital. Mr Evans has a few thoughts on that subject.

“My gut feeling, based on the conversations I’ve had with some investors, is that some investors would take their money and run,” he said. “There are some small ILS investors, treating it as a test, and if a loss happens before they become comfortable with these investments, then sure, we could see a lot of investors disappear.

“However, there are other investors who say that if you saw a major loss then they would put more money in to take advantage of the higher yields that would follow. And there are others sitting on the sidelines, waiting for a major loss before they get in.

“So I don’t think there is any chance of investors upping sticks and leaving the market. These investors are not naive. They understand there is a risk they could lose money, just as they could lose money when they invest in a tech start-up.”

He said problems could arise if a cat bond were triggered by types of losses that were not envisaged or understood by investors. Such problems could lead to lawsuits, and meant that sponsors had to take great care in drawing up terms and conditions, he added.

Global issuance of ILS has now topped the $20 billion mark and Mr Evans expects next year to bring further growth.

“Prospects for 2014 look good, with investor appetite high and a growing number of new sponsors accessing the market regularly. The market should continue to grow in 2014 and at Artemis.bm we are quietly confident that the overall reinsurance and ILS asset class will also continue to grow,” he said.

Useful website: www.artemis.bm