Investors see significant value in ILS despite reduced spreads: WCMA

The start of 2014 saw increasing participation in the insurance-linked securities (ILS) space from money managers and mutual funds investing in the asset class directly, as the ILS investor base broadened in Q1.

Interest from new investors in ILS, insurance and reinsurance linked investments continues to grow, according to the first-quarter ILS market update report published by Willis Capital Markets & Advisory, the capital markets and ILS focused unit of global insurance and reinsurance broker Willis.

Investors continue to show a strong interest in ILS and insurance linked investing, despite the lower pricing on catastrophe bonds and property catastrophe reinsurance in general, and this is continuing to bring new investors to the asset class as they get introduced to the benefits of a diversifying source of yield with a low-correlation to wider financial markets.

Bill Dubinsky, Head of ILS at WCMA, explained; “Money managers, mutual funds and ILS specialist investors still see significant value for their investors despite the fall in market clearing spreads. Note that a modest tick upwards in spreads would bring in a significant amount of additional capacity. As a consequence, the risk of running out of capacity seems limited.”

WCMA’s latest ILS Market Update report, subtitled ‘Declining Spreads & Flexibility in Structuring’ takes a look at non-life catastrophe bond issuance during the first-quarter of 2014 and discusses emerging ILS market trends.

The report notes three factors driving issuance in 2014; the decline in spreads making risk transfer through ILS and cat bonds more cost-effective, the increased flexibility available within ILS and cat bond structures, which makes the coverage available more comparable to traditional reinsurance protection and increased speed to market which is reducing lead times from decisions to proceed to actual deal execution.

For potential sponsors, the attraction of being able to diversify their sources of risk capital using third-party and capital markets investors, at ever decreasing pricing thanks to the low-cost of ILS capital and while securing reinsurance coverage that is getting closer to matching what can be achieved in the traditional market is a strong draw.

Combine this with continued low-interest rates in the financial markets, an investor base that is increasingly educated and willing to support reinsurance transactions, a growing need for diversification in the portfolios of institutional investors and a recognition that reinsurance as an asset class can provide long-term yield and capital appreciation and you can see why the attraction is growing and investor base broadening.

“There are several factors driving the uptick in deals. First, new issuance risk spreads have continued to trend downwards falling from 12.0% in Q3 2012 to 6.4% in Q1 2014. Second, terms have become more flexible to allow for deals tailored to a sponsor’s needs. This flexibility can sometimes increase risk spreads but sponsors at least have increased options. Third, speed to market is improving, reducing lead times between decisions to proceed and execution. Finally, sponsors and their brokers are getting better at resisting the siren call of overpriced private placements,” added Dubinsky.

WCMA recorded six non-life catastrophe bond transactions in Q1 2014, totaling $1.2 billion of new issuance. WCMA only includes broadly marketed 144A non-life catastrophe bond transactions in this number, hence why it falls a long way short of the $1.585 billion of new issuance recorded in the Artemis Deal Directory.

Dubinsky’s comment on private placement is interesting. The report notes that specialist ILS investors have been targeting both syndicated collateralized reinsurance and private placement collateralized reinsurance transactions as a way to avoid the competitive syndication of broadly marketed cat bonds.

Sometimes investors have been able to preempt cat bond placements by securing coverage at private placement terms, but often that is at some cost. To secure the deal on private terms can cost the sponsor more than a broadly marketed cat bond syndication, so occasionally the sponsor can miss out on the potential for a lower spread.

The report notes that lately this preemption is on the decline, hence the comment that sponsors and brokers are resisting the private placement ‘siren call’. Sponsors now appreciate that a private placement will typically occur at a higher spread than a syndicated deal, even taking into account relative frictional costs.

WCMA notes in the report; “The private placement concentrates market power to the detriment of the sponsor as opposed to a syndication which increases its number of relationships. In truth, now that cat bonds have more flexible terms and conditions, the justification for private placements has become increasingly difficult.”

This shows that it’s not just investors becoming better educated about the ILS market, it is sponsors too who are learning an appreciation for the coverage, terms and especially pricing available to them. A move back towards the syndicated transaction could help to stimulate more rapid growth of the catastrophe bond asset class, which would be welcomed by investors in ILS.

As we wrote earlier this week, Willis believes that the catastrophe bond pipeline for the second-quarter of 2014 is very strong. This report reiterates this fact and explains some of the reasoning. With over $850m of new cat bonds already being marketed in April, Q2 issuance has certainly got off to a brisk start.

WCMA says that it expects a strong level of Q2 issuance as the cat bond and ILS deal pipeline is developing on the back of successful executions in the first-quarter. As would typically be expected of Q2 cat bond issuance, the bulk of the deals which come to market are expected to be U.S. wind exposed, with a few opportunistic tranches of risk issued to go some way to satisfying investor demand for diversifying risks.

In fact, WCMA is bullish about prospects for the second-quarter, saying that the factors it identifies in its report of an increased speed to market, attractive pricing, more favorable terms and increasingly educated sponsors and investors, could lead to a record Q2 issuance for non-life cat bonds.

WCMA puts the record for the second-quarter as $2.6 billion in 2007 and says that Q2 of 2014 has every chance of beating this figure. That would please the investor base, help to assure further outright growth for the ILS market in 2014 and set the year on course for another $7 billion plus total.

Going forwards, WCMA notes that as spreads have declined on cat bond issues and secondary cat bond pricing has been pushed up eroding margins there as well investors will likely be on the hunt for higher yielding issues than can help them to maintain their return targets.

This could result in more private placement demand as investors seek higher returning layers of risk and may be pushed to pursue private deals to boost the lower returning cat bond yields. Of course it could also make issuance of cat bonds with higher spreads more attractive again.

There could be an interesting dynamic that emerges if cat bond spreads continue to stay low and the market continues to issue sub-4% yielding bonds. Dedicated cat bond investment funds may struggle to maintain return targets in a year or two’s time, which could either lead to them having to adjust their mandates to include private deals and collateralized reinsurance or some funds having to consider more drastic actions such as closing and returning capital.

We suspect that the market will begin to support the return ambitions of these investment managers with the issuance of some higher risk and return cat bond tranches. For potential sponsors looking to how best to transfer risk from the higher layers of their reinsurance tower, the cat bond market must be looking particularly attractive right now.

You can access the full report from Willis Capital Markets & Advisory here.

Also read Artemis’ report on first-quarter 2014 catastrophe bond and ILS issuance:

– Record first-quarter as 2014 catastrophe bond issuance starts strongly.