A new paper from Milliman, a consultant to the insurance and financial services industries, discusses the ongoing transformation in and of the global reinsurance industry that alternative investment has created.

About 20 years ago, in the wake of Hurricane Andrew and the Northridge earthquake, catastrophe bonds caught on as a way for pension funds, sovereign wealth funds, and high net worth individuals to invest in the reinsurance market. In essence, the investors bet against a specifically defined event such as an earthquake of a certain degree of magnitude.

The risk is made tolerable for the bettors, that is, for the investors who buy the CAT bonds, in part due to the short maturity of these instruments, typically five years or less.

But the influx of money that Milliman has in mind goes beyond those instruments. It also includes private deals such as reinsurance sidecars, which came into fashion after 9/11.

Decline and then Rise Again

Interest in reinsurance waned as a consequence of fall-out from the GFC. Lehman Brothers defaulted on four bonds in each of which it had served as the counterparty on the bond’s collateral. This sent financial investors with exposure in this space scrambling, as Milliman puts it “to understand their investment portfolios and the inherent risks therein.” They came to understand that although they had thought this investment was uncorrelated with other financial assets, indeed that was part of the initial appeal (and surely the occurrence of an earthquake is uncorrelated with the risk of stock market price falls and the like) they found that such instruments are highly correlated (as a matter of counter-party risk) in a tail event.

The financial engineers went back to the drawing board, improving the instruments involved, and interest revived around 2011. By the end of 2016, Milliman says, alternative capital in the catastrophe space consisted of around $76 billion, which breaks down as follows: