Roundtable: What are the challenges of evolving insurance-linked securities structures?

As the insurance linked securities (ILS) and catastrophe bond market evolves and innovates the structures designed to support the markets transactional needs change. This roundtable discusses some of the issues surrounding this with key industry participants.

This roundtable is taken from the recently published report by specialist financial services, pensions and investments publisher Clear Path Analysis, titled ‘Insurance-Linked Securities for Institutional Investors 2014.’ Artemis owner and editor Steve Evans chaired the roundtable and Clear Path Analysis have kindly allowed us to republish it here in full.

Roundtable participants:

– John Whiley, Head of ILS Administration, SS&C GlobeOp.
– Daniel Ineichen, ILS Portfolio Manager, Schroder Investment Management.
– Stephen Rooney, Partner, Mayer Brown.

Steve Evans: The insurance-linked securities (ILS) marketplace has evolved to sufficient size to now be considered durable, robust and investable but in doing so what operational challenges has this created?

John Whiley: At SS&C GlobeOp, we provide ILS administration services to fund structures and sidecars that require institutional investor reporting. Whether we work with an independent manager investing in the asset class, a hedge fund sponsored ILS manager, or a reinsurer supported ILS manager, the challenges remain the same.

Getting the rules of the game correct from inception is essential so the ILS Manager can articulate why a particular option represents the best alternative for their investors. These rules relate to how the launch capital will be invested into the structure and how the structure will provide liquidity to the investor, especially when there are loss impacted contracts. For launch capital, what we see today, are subscriptions being processed on a commitment basis to ensure there is ‘just in time’ capital rather than excess cash being left on the balance sheet creating a return “drag”. Typically there’s a ramp up phase when dealing with an illiquid asset that requires the subscription flow to deploy over a six month period, unless there is a quota share of an existing book of business.

Traditional open ended fund mechanisms for restricting liquidity such as lock-up periods and gates generally do not work well in the ILS fund context. This has led to the use of redemption shares or slow pay shares to manage liquidity on a redemption basis and enable investors to exit the structures. Redemptions may take between six and twelve months on the liquidity side, whereas a pension investor working with a traditional reinsurer can take years to exit.

Given there is often performance-based compensation paid by the investor to the ILS Manager, our job as an independent administrator is to ensure the rules of the game are followed and adhered to throughout the investment term with experienced people and processes, whilst providing transparent reporting.

Daniel Ineichen: Firstly I would like to make a distinction between the tradable market, catastrophe (CAT) bonds, and other types of insurance risk. Main challenges are also with regard to are increased regulatory requirements and general pricing policies that we have to adhere to under the diverse regulatory schemes. Challenges are definitely larger on products that invest in private transactions and here the liquidity management is a main topic as investors roll a contract into a new one.

Collateral management is a big focus that has come under increased attention and equally so has the discipline within the reinsurance industry to adhere to more timely information requirements that we, as fund managers, usually face compared to the traditional reinsurance market.

We have had to extensively educate investors on how it works and also reinsurance counterparties on what our needs are. The last point to make is definitely around the validation of those private transactions where we have put a lot of effort in. If the market evolves to become even more robust and bigger we need to have a very sound valuation regime for all different types of transactions in place. To achieve this we created for instance processes bringing in independent views for the valuation of our policies.

Stephen Rooney: It’s interesting that both Daniel and John have touched on transparency and liquidity. As this market has grown it’s interesting to observe the number of sponsors who are accessing the market through a 144A, relatively liquid format in the form of a CAT bond, versus a private placement instrument. There have been offerings of participating notes in sidecar vehicles as well as various kinds of equity interests in sidecars or dedicated vehicles.

There’s a range of instruments, with differing liquidity profiles, which investors can explore. Over the last year and a half the market has expanded significantly with a lot of innovation and choice. Even within the more conventional CAT bond market there has been a lot of variation, with many more indemnity triggers, including an increasing number of aggregate indemnity triggers. These imply that there is a greater need for real time disclosure to investors with regards to the losses that count towards the aggregate trigger.

We’re also seeing companies attempting to access the market quickly and in doing so are deciding not to have ratings or are running limited kinds of risk analysis. This means that even within the conventional CAT bond there are several differences emerging amongst the transactions. As the market grows it’s important that investors can distinguish and understand what’s being offered; it’s a challenge on all sides of the transaction to structure it in a way that is understandable and transparent whereby the market can assess and properly price the risk.

Steve: The absence of yield in other asset classes is pulling ILS instruments away from the ‘alternative’ bucket towards mainstream investment tools. What challenges and opportunities is this likely to create for investment managers?

Daniel: We definitely observe this shift and in particular for the 144A bond part, allocations have moved out of the alternative bucket and are increasingly coming from the fixed income side which of course, creates different challenges. We speak to clients in a different language and so in many respects it is a translation exercise from the reinsurance language into more natural financial market language.

As the degree of education from our own clients has increased so has the need for transparency because different investors approach the sector differently and therefore need that transparency in order to understand where the risks have evolved from. For example, on the 2nd April there was a strong earthquake in Chile. As the general response to disasters such as this has quickened so have incoming investor queries and it is fair to say that the communication we have to have with our investors has increased also. We have to find a line on how we communicate in a trustworthy manner with reasonable, accurate information rather than just issuing a blanket statement.

From a trading side I welcome the new breed of investors who have brought additional liquidity into the market as a result of increased sell and buy motivations, different to the buy and hold dominated players prevailing a few years ago. Now there is much more activity around reallocating portfolios which has subsequently led to another level of liquidity in the tradable market. We have also observed a shift in relative values from market segments because some investors are playing only in the liquid space as opposed to others that access the entire ILS market. As a manager we consider it to be more and more important to facilitating the entire ILS capital market. There are different and significant shifts in terms of relative value between the segments, much more accentuated than say 3 or 5 years ago.

John: I would give it a deeper context. Pension assets are worth around US$30 trillion globally, while hedge fund assets are expected to top US$3 trillion in 2014. This is in comparison with the traditional property reinsurance limit of approximately US$300 billion and an ILS asset class that stood at US$50 billion, with approximately US$20 billion of that in CAT bonds at the end of 2013. A recent research report issued by Barclays Capital indicated that the ILS asset class could reach US$100 billion in the next few years.

Evidently it’s clear investors are attracted to the ILS asset class because of the returns, diversification and low correlation to equity and traditional bond markets. But this has had an impact on the underwriting cycle where the property catastrophe renewals in the traditional reinsurance market were reported to be down between 15 to 20% in January 2014 and by 20% in the ILS market, with CAT bond yields being compressed by more than 30% since 1 January 2013.

With a decrease in the return profile as the demand for ILS slowly exceeds the reinsurance market’s capacity to offer this asset class; ultimately, the return on investment will be lower for all market participants. It’s going to change some of the rules of the game. Managers will increasingly work harder for less, with lower performance based compensation given lower returns. ILS managers are managing investments that pay on insurance losses. I anticipate those losses will develop the market, as they did in 2011, but equally, will attract new investors as the return profile improves following loss events. This will then likely lead to Pension investors deploying capital that has been sitting on the sidelines.

Stephen: I’ll add one comment but am interested to hear others’ reactions. Market participants discuss what impact the next very big event will have on this marketplace and whether investors, who have been attracted to the asset class because of the yield considerations and lack of correlation, will react adversely to significant losses.

Under the traditional insurance market dynamics if the market experienced losses it was an opportunity for those who survived the catastrophe to increase their premium rates. However now, the industry is asking whether that dynamic will hold; assuming of course that there is a continuation of capital attracted to the market and that investors will be willing to double down. There are certainly questions as to how the influx of new capital will impact normal pricing dynamics following a big event.

Daniel: The market has grown significantly but has not really been tested since it has done so. In my experience from the past, pension schemes that started entering the market early and made allocations in the past, have rarely ‘run for the door’ post a big event. They take a long lead time to ensure that they understand what they are buying and often allow for increasing their allocation in a second step in order to benefit from the more attractive yield environment post catastrophes.

In the past, the introduction of cat models has lowered the volatility of the pricing cycle in the reinsurance industry. If capital markets now step in more aggressively post a catastrophe and provide the necessary back-up capital then the pricing cycle’s volatility may be further smoothed. Nevertheless it will remain a cyclical market because risk capital comes and goes; that’s how the market works and it will continue to do so.

The main issue is really around how some investors in the liquid space will react. With medium type catastrophes, like Hurricane Sandy, people tend to stay very calm and disciplined but with bigger ones they might pull the trigger more quickly. There may well be trading opportunities post catastrophes and the key to success is around the ability to structure products so that they can both survive and benefit from any dislocating event.

John: The pension and hedge fund investors we meet with understand the asset class and that capital is invested to cover potential losses. They also understand the return opportunity following a loss event.

The investment being made is more efficient than traditional reinsurance because it allows institutional investors to enter and exit in accordance with the governing documents of the structure. A number of these investors have been around the asset class a long time and have been invested with asset managers with proven track records during loss impacted years.

We have been working with an ILS manager since 2002. Managers with performance records dating back 10+ years are building benchmark returns for the pension investors to consider. I believe the next significant event will provide a snap-shot in time for investors to compare manager performance records allowing for new capital commitments to be deployed, further developing the ILS asset class to the $100 billion threshold.

Steve: How can pension schemes, traditional reinsurers and ILS providers ensure that they are legally compliant when operating across multiple jurisdictions?

Stephen: The simple answer is to get experienced legal advice and structure deals accordingly. Generally speaking there is relative clarity in insurance regulation which has helped the market to develop. Obviously Bermuda, the Cayman Islands and Ireland have been the primary domiciles for the vehicles that actually assume the risk and their regulatory regimes have been clear and relatively user friendly. There is an ever changing regulatory landscape in both the U.S. and in Europe, however, which has required sponsors and investors to adapt and refine their structures in order to remain compliant. There are insurance rules around collateral arrangements and complicated tax laws in both the U.S. and in Europe that need to be addressed.

To date structures have been able to deal with these regulations but going forward there is always the risk that these laws could change and the required transaction structures will have to adapt. The advent of the Dodd-Frank Act and similar complimentary regulations in Europe around regulating derivatives has made life interesting for lawyers in this area, particularly as some of those regulations are continuing to evolve. This has impacted on transaction structures and has served as one of reasons as to why we are seeing more transactions being structured on an indemnity triggered basis.

John: To pick up on Stephen’s comment I would stress the importance of hiring quality service providers including lawyers, auditors and ILS service providers. Ensure that they’ve got a deep bench of talented staff with experience on a variety of ILS transactions and structures. Bermuda has been evolving in this asset class which has been providing a reinsurance return to institutional investors for 20 years. For Bermuda it comes down to having a proactive and welcoming government, regulator and an experienced professional services sector who have supported innovation around the reinsurance and alternative investment asset class.

New CAT bonds will continue to be structured and listed on the Bermuda stock exchange, new side-cars will be created to cede risk from Bermuda reinsurers, and new Bermuda fund structures will be formed to invest in these securities. In doing so, it brings new and existing investors to the island. If you’re a Bermuda reinsurer transferring risk to one of these vehicles, it makes sense to have the company formed in the same jurisdiction, dealing with the same regulator and governance requirements. It’s a lot easier to manage and navigate when you have the professional service providers focused within one jurisdiction rather than having to manage across multiple jurisdictions.

Daniel: The insurance market is developing continuously on the regulatory side, particularly for the insurance industry’s capital markets. It has definitely been a challenging development and it is of clear advantage to have both global service providers and operations in the right jurisdiction. Moreover, what is valid today may not be appropriate tomorrow and therefore, it is important to keep in constant dialogue with regulators and have the right in-house capabilities.

Steve: Given that it is a more complicated and unusual marketplace what additional analysis and due diligence should pension schemes seeking, or extending, exposure introduce?

Daniel: It definitely is complicated and we see due diligence requirements evolving extensively, even though pension schemes are very advanced in their governance. We always urge investors to understand how risks are structured, what the real exposure of a certain product is and how this exposure is managed; particularly in relation to tail risk. I always urge clients and potential clients to determine their objectives and what their risk appetite is for a particular strategy.

We also encourage them to assess the operational set up of a manager because this is where the regulatory question feeds directly in. It is crucial that an ILS manager has very sound operations and clear processes that include the risk providers. Given that ILS allocation tends to be smaller, we often observe the due diligence to be outsourced to specialised boutiques. Given the complexity of the asset class we believe this is a very wise move.

Stephen: Diligence is extremely important in this marketplace. This is an asset class that is very complicated and as I was saying earlier, even those 144A relatively liquid CAT bonds being offered today, have significant differences amongst them. There are refinements constantly being introduced to structures from variable reset provisions, extension provisions, provisions on reduced interest and collateral provisions that are quite nuanced. Given this, investors need to pay close attention and look carefully at the disclosure document and analyse the risk.

The transaction complexity has increased so has the level of transparency. There’s a lot of diligence to do for any institutional investor in these transactions and as you move into the more illiquid transactions the level of transparency differs and the diligence burden increases. It’s an interesting and challenging market for anybody who is putting their money to work here.

John: Ultimately due diligence groups and institutional investors are becoming more educated on the asset class and the governance expectations around key administrative processes, calculations and functions. The historic ‘tick the box’ on service providers is a thing of the past and instead there is a more rigorous operational due diligence process today whereby sophisticated investors are now asking ‘how do you do this?’ and wanting to see evidence of that process in place.

The inherent conflict of interest between investors and managers, who are often paid based upon investment performance driven by unrealised gains, has led both investors and regulators to mandate the adoption of independent service providers to the alternative investment industry. The trends we have observed at SS&C GlobeOp equally apply to the ILS asset class and include a 30% increase in due diligence meetings with investors, as well as a significant increase in the sophistication of questions posed during meetings.

The review of the operating processes to ensure cash payment controls are in place; segregation of duties exist between the trustee, manager and administrator; asset verification and review of valuation policies; and transparency reporting are key. The need for experienced independent service providers with global operations who fulfils all aspects of the due diligence process is an absolute must as the industry moves forward.

Steve: Thank you all for sharing your views.

Transcript end.

The report from Clear Path Analysis is available to download today.

Visit the Clear Path Analysis website to register to download a full copy of the report ‘Insurance-Linked Securities for Institutional Investors 2014‘ including all of the interviews and roundtables.