The rapid growth of insurance-linked securities is changing the playing field for traditional catastrophe reinsurers, creating price competition and forcing reinsurers to redeploy capital — in many cases into their own start-up ILS units.

Rather than battling for dominance, though, ILS products and traditional reinsurance are evolving to complement one another, offering varying advantages to buyers along with greater capacity and pricing efficiency, observers say.

“We still think there's a complementary relationship between the two markets,” said Paul Schultz, chief executive of Aon Benfield Securities. “Markets are just going to operate differently. I don't think one is going to cannibalize the others.”

“There will be multiple winners from multiple camps,” said Greg Hagood, Nashville, Tenn.-based co-founder of ILS fund manager Nephila Capital Ltd. “It's not an us-versus-them argument.”

“Convergence capital” — including catastrophe bonds, collateralized reinsurance and industry loss warranties — is still a relatively small part of the property catastrophe market they primarily serve.

In a global market with $313 billion in property catastrophe reinsurance capacity, traditional reinsurers still provide about 86% of the total, according to reinsurance intermediary Guy Carpenter & Co. L.L.C. Cat bonds accounted for 5%; collateralized reinsurance, 4.8%; retrocessional products such as sidecars, 2.6%; and industry loss warranties, 1.9%, Guy Carpenter reports (see chart).

The ILS market is in a boom period, though. New property cat bond issues totaled $4.8 billion in the first seven months of 2013 and for the full year could surpass the record of $7 billion issued in 2007, according to Guy Carpenter. Outstanding bonds totaled $16.6 billion as of July 31, an all-time record.

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The flood of investor capital has helped push down bond yields to the point where they are sometimes cheaper than traditional reinsurance, and reinsurers have responded by cutting their own rates, observers say.

The ILS alternative is having other effects besides price competition for property cat business, said Robin Swindell, executive vice president with Willis Re, the reinsurance arm of Willis Group Holdings P.L.C., in London. Some reinsurers are shifting capital to cat perils that ILS markets don't typically cover, such as Japanese earthquake risk; to long-tail casualty lines, including niche lines such as surety and credit reinsurance; and even to writing direct insurance for large corporations, Mr. Swindell said.

Overall, the growth of third-party capital could displace up to $40 billion in traditional reinsurance equity capital, which reinsurers may return to shareholders or redeploy elsewhere, Willis predicted last month.

ILS investors, meanwhile, will look for new ways to use their own capital and may expand beyond the high-layer property cat risks where they have a price advantage over traditional markets, observers say.

For instance, the new capital could move into lower layers of catastrophe programs or into marine, aviation or terrorism exposures, they say. And while ILS products historically have been aimed mainly at big global cedents, fund managers may increasingly seek out regional insurers, a “democratization” of the market made possible partly by ILS products adopting the indemnity triggers smaller cedents are more comfortable with, said Michael Popkin, managing director and co-head of the ILS practice at Towers Watson Capital Markets Inc. in New York.

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ILS market growth still faces “significant headwinds,” said William Donnell, president-U.S. property and casualty reinsurance with Swiss Re Ltd. in Armonk, N.Y. Investors have already gone after the “low-hanging fruit” of U.S catastrophe risk and are facing a future of rising interest rates that could draw away capital and the challenges of expansion into lines that aren't modeled as thoroughly as U.S. cat risks, he said.

Despite competitive skirmishes, though, ILS products and traditional reinsurance are likely to co-exist and complement one another as the market evolves, several observers say.

Traditional reinsurers are more flexible as underwriters, offering terms and products not available from ILS investors: reinstatements of limits, for example, or multiline property and casualty covers, reinsurance sources say.

Traditional reinsurers also emphasize services not as widely available from ILS managers, including benchmarking, audits and risk management consulting, said Mr. Donnell.

That added level of service “de-commoditizes” reinsurance transactions, he said.

ILS providers, with their relatively low cost of capital, bring pricing efficiency to model-friendly risks, moderating the peaks — and potentially the troughs — of market cycles, said Kevin Madigan, director of actuarial and insurance management solutions with PricewaterhouseCoopers L.L.P. in Saratoga Springs, N.Y.

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ILS capacity also will fill gaps where traditional reinsurers' risk appetites fall short: New York's Metropolitan Transportation Authority this year placed a $200 million cat bond for storm surge risk through GC Securities after finding traditional reinsurers were concerned about over-concentration of risk in lower Manhattan, said Chi Hum, global head of ILS distribution for GC Securities, a unit of MMC Securities Corp. in New York.

“This is not going to displace reinsurance. It's another reinsurance type of option,” said Joe Calandro, managing director with PwC's insurance practice.

Traditional and convergence capital are increasingly likely to co-exist within the same companies, with large reinsurers setting up or expanding ILS operations and ILS investors forming more traditional underwriting arms such as Lloyd's of London syndicates, sources predict.

Underwriting managers will be able to tap different “balance sheets” — traditional equity capital or ILS capital — to fill out programs as needed, said Rick Miller, a Towers Watson Capital Markets managing director and co-head of its ILS practice.

Over the next two to three years, he said, “it will become increasingly difficult to distinguish between reinsurance underwriters and portfolio managers.”