ILS and catastrophe bonds are not sub-prime mortgages

The transparency of the insurance-linked securities (ILS) market alongside comprehensive third-party models, and sector sophistication underlines its differences from sub-prime mortgages, according to Aon Securities Chief Executive Officer (CEO), Paul Schultz.

From time-to-time some have sought to comment on the apparent similarities between ILS, catastrophe bonds and other reinsurance linked assets and sub-prime mortgages, which were a significant element of the mortgage-backed securities crisis in the U.S. during 2008, contributing to the global financial crisis.

From the outside and to those uneducated in the asset class or reinsurance, ILS or cat bonds and sub-prime mortgages can appear to have similarities in the way the risks can be pooled and structured, notes Schultz, before underlining the fundamental differences between the structure of the market for transferring insurance risk when compared to the market for mortgage-backed securities.

“At the time of the sub-prime mortgage crisis the market lost discipline in the way it was underwriting, and so it began to ignore the standard metrics about how you lend money,” explains Schultz.

But the ILS sector is far more transparent than the market for mortgage-backed securities, with regards to the underlying risks and how the deals are structured, explains Schultz in an article published today.

Furthermore, the level of sophistication in the ILS space is growing all the time, both from sponsors and investors alike, supporting the development of a mature and viable asset class, which Schultz feels is unlikely to experience the kind of meltdown witnessed in the mortgage-backed securities market in 2008.

Schultz underlined the growing sophistication of ILS investors in the space, saying; “We spend a great amount of time as a firm and as an industry educating investors on the asset class. Furthermore, we don’t sell securities to small investors – you need to have $100 million of assets to invest in this class, so investors tend to have a greater level of financial acumen.”

Catastrophe bonds make up a significant part of the ILS market and issuance levels in recent times have seen the sector continue down its impressive growth path, supported by increased investor and sponsor appetite to access catastrophe exposed reinsurance business lines.

Interestingly, another article that emerged today in Bermuda’s Royal Gazette quotes an analyst as saying that the catastrophe bond market “sounds eerily familiar to the way investors behaved towards another seemingly obscured bond market before the financial crisis.” The article also warns of capital fleeing the sector if investors are hit by losses they did not anticipate or understand could happen.

But as highlighted by Schultz, and evidenced by the markets sophistication and continued expansion, the ILS market is not the same as the sub-prime mortgage, or mortgage-backed securities market, and is very unlikely to meet the same fate.

As with any tangible asset, catastrophe bond pricing can fluctuate based on supply/demand factors and seasonality dynamics, but the independent, comprehensive third-party models available to investors provides increased transparency of the underlying risk of the security.

Aon explains that this gives investors an independent view of the risk that is specific to a catastrophe bond, emphasising the asset classes’ extremely low correlation to the wider financial markets.

ILS’ low correlation to broader financial markets is clearly an attractive element of the market to investors. But apart from the obvious diversification benefits it also shows another way in which ILS differs from the sub-prime market, as the meltdown experienced here greatly contributed to the global financial crisis.

“The insurance industry has highlighted this benefit since the inception of the market back in the mid 1990s, but really until the global financial crisis didn’t have hard data,” explains Schultz.

Supporting this statement, Schultz highlights how during the financial crisis of 2008, which the sub-prime mortgage market collapse contributed to, Aon’s ILS indices for property catastrophe bonds reported positive returns during the period.

The differences between ILS and sub-prime mortgages appear clear and plentiful, underlined by sophistication, transparency and the fact that more and more investors are either returning to the space or entering it for the first time, demanding increased information about deal specifics and the underlying risks.

Highlighting the asset class as akin to, or reminiscent of, sub-prime bonds seems a lazy way to avoid delving into the idiosyncrasies of what is a sophisticated asset class, with significant security to it for its investors.

The ILS and cat bond market features instruments structured, modeled and underwritten by experts, largely backed by highly sophisticated investors and of course fully-collateralised by real assets, with cash or equivalent values.

And on the subject of investor capital fleeing the sector after losses, it is generally accepted that ILS investors are aware of and in many cases appreciate that they are providing re/insurance capital, designed to pay out for losses when the worst occurs and that risk is exactly what they are being compensated for with coupons and returns.

Not to mention the fact that ILS and cat bonds are instruments for insurance risk transfer providing disaster risk capital, not for the financing of pools of opaque and poorly explained assets.

Given the transparency of the underlying risks transferred, gained through risk modeling and the robust legal disclosure, investors and investment managers are as well appraised of what they are allocating capital to in ILS as they would be in any asset class available in financial markets today.