Roundtable: What is the future for insurance-linked securities?

The insurance-linked securities market continues to evolve and grow but what next and what issues may arise? This roundtable, titled ‘What is the future for ILS and is broader participation in new reinsurance areas appetising?’, discusses these questions and more.

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:

– Aashh K. Parekh, Managing Director, Global Public Market, TIAA-CREF.
– Isaac Anthony, Chief Executive Officer, Caribbean Catastrophe Risk Insurance Facility (CCRIF).
– Dan Bergman, Head of Investment Research & Insurance-Linked Securities, AP3.
– Dirk Lohmann, Chairman & Managing Partner, Secquaero Advisors.

Steve Evans: Is there a drive towards broader participation in the reinsurance market?

Dirk Lohmann: If you define insurance-linked securities (ILS) as capital markets I would say yes; although the question is around what form that capital market participation will be. There have been recent developments amongst new reinsurers, backed by hedge funds, to focus increasingly on areas such as casualty. That said, I don’t know the extent to which they are really involved in reinsurance; I rather feel it is more a method for securing permanent capital for hedge funds. This increased amount of capital includes a lot of sidecar involvement which technically, allows investors to participate in a broader range of reinsurance than would be the case if they were limited to bonds.

In ILS specialist funds where managers have their own transformers, there 
is an increasing trend of investing in non-catastrophe related risk that may be short-term in nature. One such manager recently announced they also invested in per risk transactions and I see activity likely to continue in that direction.

Aashh K. Parekh: At TIAA-CREF we work with many different accounts
all of whom have varying degrees of interest in the broader reinsurance market. Essentially it depends on how the ILS market reacts to the current dynamic. We’ve experienced some spread compression in insurance-linked securities, also known as catastrophe (CAT) bonds.

The answer to this question depends on whether or not demand can
be met with supply through the traditional securities market; if the supply continues to be constrained, despite the fact that spreads have compressed, ILS will be competitive with reinsurance markets in some places. If that increased demand isn’t met with increased supply, then some of our accounts will find it compelling to expand capabilities and branch out beyond traditional CAT bonds.

Dan Bergman: I’ll take the starting point to be how we act and what types of investments we might consider as part of the broader reinsurance market. We are in this market for the long-term in order to get good risk adjusted returns and diversify our total portfolio. As a pension fund we invest globally 
in a broad range of asset classes but still, our portfolio risk is dominated
by equities. Consequently we value asset classes with good risk adjusted returns, not correlated with equities; ILS provides just that, it diversifies and improves the efficiency of our total portfolio.

Thus, a natural strategy for us when building our insurance exposure is
 to invest in a smaller number of well-priced risks. We don’t presently feel
 a need to access new types of risks
 or perils, rather we focus on finding well priced risks that we can access efficiently. This may differ somewhat from, for example, a hedge fund dedicated to this space (or a traditional reinsurer for that matter) where the entire risk can be insurance or CAT related. I don’t see a strong interest from our side to grow this market into new areas; our strategy does not require that.

Isaac Anthony: We definitely believe there is a drive towards broader participation in the reinsurance market through multiple fronts, as ILS investors become more sophisticated and develop their in-house underwriting capabilities.
 At CCRIF we are very reliant on the reinsurance market and are actively trying to source the best pricing. This year we are seriously looking at the possibility of getting involved with CAT bonds and potentially, collateralised reinsurance. From our perspective this is very important as we feel this market expansion presents us with some excellent opportunities.

Dirk: To add to that, I would put the question out there as to why there is an interest in this broader participation; the answer of course being the diversification offered by this asset class. The bond universe alone
is highly concentrated by U.S. wind which in turn has generated some 
very significant quake aggregates, as many national accounts sponsoring bonds that are principally exposed by hurricane also throw in the earthquake risk as a secondary peril. This is all
 fine and good if you’re taking the AP3 approach, for example, where you say we don’t need diversification within that asset class because it naturally diversifies against other asset classes and because your allocation is going to be small. Certainly there is an investor base out there allocating to managers like ourselves in order to gain both 
the diversifying and non-correlating nature, and are equally desirous of limited draw down on their investment.

The reality though is that if you have a bond only strategy the draw down risk on the principle that you commit can be quite severe, simply because of the high concentration of hurricane risk in the bond universe. This has caused a proportion of investors to increase the amount of diversification that they seek.

Aashh: When we compare the characteristics of the ILS market components to the other capital markets that we participate in, one thing we observe is that the ILS market isn’t as mature as other markets. Whilst there is a fairly active primary risk pipeline the secondary market is not very well developed and frequently it is the case that there isn’t much liquidity.

Secondly, the broader reinsurance market brings other types of risk to 
the table that aren’t observed in the ILS market. Moreover, it’s frequently the case that even for the same peril, with some adjustments for risk profiles, documentation and contract language, you can actually be paid more for taking on similar kinds of risk but in a different format. From that standpoint our investors are on a risk adjusted basis looking for the most return and in some instances would find other reinsurance formats, not just ILS, equally compelling.

Dan: The pull-back
 of many of the
 larger traditional 
U.S. insurers from
 coastal areas has 
left substantial
 hurricane exposure
 with different residual markets. Over the past couple of years we have seen how more and more of these risks have found their way to the collateralised reinsurance market and even the 144A CAT bond market. I expect this development to continue and it is certainly beneficial to these coastal communities to obtain coverage for their hurricane risks at competitive price levels. This is one example where the development of the ILS market serves society well.

Isaac: On a standalone basis we are seeing increased interest in energy, marine and agriculture. There is also extremely high demand for the non-peak national capacity perils because they appear to be offering greater diversification and good value for regions such as the Caribbean, Central and South America. This is ultimately driving pricing convergence within traditional markets and additionally, the various buyer are then helping to provide multi-collateral capacity, which further increases market competitiveness.

Steve: What are the present constraints on the key market players, from the asset owner, insurer and ILS provider’s perspectives?

Aashh: Spreads are tighter in the current market environment relative 
to 12, 18 or 24 months ago. From a risk standpoint it is additionally challenging for some markets to achieve the desired amount of diversification just by participating in CAT bonds alone. In terms of diversification, we’re talking about perils and peril regions as well as the number and type of cedants.
 I would say the ability to diversify 
in the ILS market is improving but overall investors are still limited in other formats. These are the main constraints from the asset managers’ standpoint. From an insurance company’s standpoint, some accounts are sensitive to the existence of ratings even though ratings have limited application in this asset class.

Dan: The spread compression in the broader insurance market and in particular in the listed CAT bond space has forced us to work harder and reduce our participation on several programmes. We are increasingly focusing on the traditional market and various types of private transactions in order to find better risks and pricing.

Dirk: It’s an important consideration but more significant is the relative
 size of the market. It’s still tiny and for many larger institutions if they want to make a meaningful allocation it’s hard to find enough product to satisfy that. There are huge institutional investors that understand the benefits of this asset class from a portfolio context but to move the needle on their diversification, will need to allocate several hundred million dollars. Even though the total bond market size is worth $22 billion, it’s not very big and there’s not much liquidity. It’s a niche market and therefore this will always be a problem until we are able to develop additional products with meaningful value for the insurance company sponsors and are fungible, in a way that institutional investors or capital market investors can own and trade them.

Isaac: From a buyers protection perspective, there are some trade-
offs in the terms and conditions of traditional markets. For example, CAT bonds and many of the collateralised reinsurance providers cannot provide reinstatements on a cost competitive basis within the traditional markets. There will be some parts of the reinsurance programme better suited to alternative markets than others and therefore, it’s important to understand and optimise how the different markets utilise the specific instruments.

Steve: The ILS marketplace isn’t as diversified as the traditional reinsurance market, where do you expect the greatest level of diversification and expansion to occur?

Dirk: The reality is that if you’re
 talking about catastrophe risk there 
is only limited growth in emerging catastrophe markets. These are markets where insurance penetration
 is increasing and where consequently, there are capacity constraints; that’s a vision of the future, let’s say in China 
in 10 or 20 years or so. Over the last 
6 to 10 months there has been an increasing use of aggregate type structures and protection against frequency, as well as severity. This
 has been one of the drivers behind increased issuance by a number of sponsors who might not have normally entered the market. To a certain degree this does add diversification, at least from a temporal aspect, in that you are more likely to
 be exposed on the second, third or fourth event rather than first. That said there are limitations because if everyone buys that cover 
then of course you will have tighter correlation within the portfolio. It’s tough to say.

Some people might say that they’ll look at terrorism because there’s 
been talk about TRIA not being renewed, when in reality it actually is being renewed. I am not a big fan of terrorism as a product for the capital markets because I don’t believe it is non-correlating; in fact terrorist events have a high correlation with capital market movements. I suspect there will be increased movement towards other perils that historically, have not been insured to a great extent, such as flooding. For this to happen there needs to be improved modelling, time and resources; however, we’re making some progress with reporting agencies such as PERILS AG, who are increasing their footprint coverage and really moving modelling on.

Isaac: Speaking more from a geographical rather product development perspective, I certainly see the greatest push to be into international emerging market zones. There has been a recent application 
of transactions in the Caribbean with growing interest in Central America and to a lesser extent in South America, including in Columbia, Chile and Peru. In Asia, the biggest developments have been in China and Taiwan 
and collectively I see this growth as the driver behind greater levels of diversification.

Dan: It’s not obvious to me that this market will expand significantly but again it depends on how you define the ILS market. Presently we see issuance from various new diversifying sources. This is in my mind is largely driven by the current attractive pricing (from the cedents’ perspective) and 
it may not be sustainable, although it can of course continue alongside
 a soft market for a number of years.
 I struggle to see it persist for the long-term. I would rather assume a moderate more gradual growth, largely driven by an increased familiarity with non-traditional capacity within smaller and mid-sized companies, particularly in the U.S. As a consequence, I expect much of the long-term growth to occur in the collateralised private space rather than in the listed 144A securities space.

Steve: There is an increased acceptance of indemnities and subsequently we’re seeing more features such as variable resets and expansion of the terms and conditions. Which new ILS instruments are most appealing and why?

Aashh: Anything that increases risk for the same price is not appealing to us. That said there are some things that we are willing to live with and others we are not willing to live without. Therefore we’re constantly re-evaluating where that line gets drawn and where the grey area is; it’s a moving target. Generally speaking, we have made the same observations that you have, in terms of the type
 of risk that makes it to market, the format of the risk and the nature of the portfolio, documentation, triggers and structural features. We see it moving in a direction that is reflective of the state of the market. In some cases we can find situations where it’s acceptable and in other cases they’re not acceptable.

Dan: My general reflection is that: cleaner is better. We see relaxed terms, an increasing number of more involved structures and some new securities with perhaps more complex underlying books of business coming to market. We struggle to find value in some of these more complex and creative transactions.

Dirk: I echo many of those comments but add that it’s welcoming to see so many new sponsors coming to the market and broadening the number of participants. What does concern me though is that, as Dan mentioned, at times there are quite complex portfolios being put to the markets, priced off a model in which the model risk is very large.

We’re returning to a situation that we had in 2005 when a bond was placed on an industrial portfolio with the model defining the expected value as ‘x’. However, when the event happened the triggering threshold event was well below the ‘x’ that the model had predicted and so the risk/return profile was off.

It is because of these situations that we have to be very vigilant regarding what type of portfolio is insured, on what basis and when an indemnity trigger is used for transferring all of that risk into the capital markets. This reflects where the marketplace is today but that said, there may still be corrections needed because who knows what surprises are yet to come. Whilst some extensions might make sense for certain types of perils, the biggest concern remains around the incorporation of portfolios that are priced with a huge model risk.

Isaac: Although we are relatively new to the market, we do see that the collateralised reinsurance and CAT bond markets are very attractive options for sponsors. The main advantage of these, certainly from a collateralised reinsurance market, is in the execution process and the additional coverage that is provided. We also recognise that CAT bonds introduce a multi capacity and a broader range of investors into the marketplace which of course helps influence our decision. These instruments provide strategic benefits in that they broaden the source of capacity over time which in turns helps better manage volatility in the reinsurance market.

Steve: Thank you all for sharing your insights.

Transcript end.

Read our other articles and transcripts related to this report:

– Institutional investor appetite for insurance linked assets remains strong.

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

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.