British regulators are scrutinizing the impact of the wave of capital from investors such as hedge and pension funds on the insurance industry.

“The availability of this additional capital inevitably affects the decisions made by insurers and reinsurers on the underwriting and pricing of risk, and on the viability and sustainability of important lines of their business,” Julian Adams, deputy chief of the U.K.’s Prudential Regulation Authority, said in a speech in London today.

Funds are increasingly investing in insurance-linked securities such as catastrophe bonds to generate higher yields as interest rates stay near record lows. About $44 billion of the $510 billion of capital accumulated in the reinsurance industry at the end of June came from such non-traditional sources, according to Aon Benfield. That growth has forced reinsurers to cut the rates they charge, threatening profit.

That pressure may prompt firms to increase the risks they take on, or diversify into areas in which they have little expertise, Adams said.

“You should expect us as the prudential regulator to be especially alert when firms’ traditional business comes under pressure,” he said.

Adams said regulators will want to know when insurers themselves use such securities that they understand the extent to which they are actually transferring risk.

“Some of these structures do not offer the same sort of reinstatement cover as traditional reinsurance,” he said. “We expect firms to analyze carefully the collateral arrangements which form part of these deals, to ensure that they are satisfied that cover will respond in all the circumstances that the insurer expects.”

Lloyd’s of London Chairman John Nelson last month called on regulators to be “extremely watchful” about the new entrants to the market, saying they could pose a systemic threat by detaching capital from risk.

–Editors: Edward Evans, Jon Menon