Willis subsidiary, Willis Capital Markets & Advisory (WCMA) feels that the surge of capital that will be looking to enter the reinsurance sector after the next large loss event will strongly favour liquid forms of insurance-linked securities (ILS).
Albeit at a slower pace than in previous years, the ILS market continues to record impressive growth and further cement itself within the global risk transfer landscape.
In recent times much of the growth has come from the illiquid collateralised reinsurance sub-sector of the space, with market conditions seemingly favouring the collateralised reinsurance space over more liquid forms of ILS, such as catastrophe bonds.
The global reinsurance marketplace remains heavily pressured and competition continues to dampen returns, leading industry discussions to circulate around the need for the removal of a significant amount of capacity in order to turn the market from its softening cycle.
It’s been reported previously that some in the space expect the surge of post-event capital to come largely from the ILS space and, WCMA has expanded further on this notion, stating that “A significant amount of the ILS capital that will flood in post-event will strongly favour liquid ILS over illiquid ILS in its various forms,” in its Q3 2016 ILS Market Update.
The standardised documentation, tradability on the secondary market, and transparency of traditional 144A catastrophe bonds provide valuable liquidity to investors in space, and WCMA expects these type of ILS structures to be more favourable than illiquid ILS investments, such as collateralised reinsurance and the majority of reinsurance sidecar type vehicles, post-event.
The majority of ILS investments come from institutional investors such as pension funds, whom, given the chance would likely favour liquidity in their investment over an insurance or reinsurance-linked investment that locks their capital in for the duration of the contract, with less transparency on pricing metrics than with a catastrophe bond, for example.
As noted earlier, and also highlighted by WCMA, “2016 has seen further growth in the proportion of investment in illiquid nonlife ILS,” continuing to add that total nonlife ILS capital is growing at over 5% annually, while liquid nonlife ILS has remained relatively flat.
This is most likely due to market conditions being more favourable to collateralised reinsurance placements over catastrophe bonds owing to market players striving for efficiency in a very difficult operating environment.
With efficiency being paramount for everyone in the space, the ease and reduced cost of participating in a collateralised reinsurance arrangement, when compared with a cat bond that can be expensive and time consuming to establish, makes a lot of sense for some market players.
However, following a large event and the resulting removal of a substantial volume of market capacity, the market dynamics will likely change (how much likely depends on the size and impact of the event), which could stimulate heightened issuance of liquid ILS to replace the lost capital.
“Protection buyers who avoid liquid ILS post-event, will likely pay dearly for the privilege as they will narrow the pool of money from which they can draw capacity,” said WCMA.
Interestingly, WCMA explains that a market changing event is unlikely to see the market return to favour liquid ILS over illiquid structures in a meaningful, lasting way, and that innovation and attracting new investors is also essential.
In its report, WCMA explains that insurers and reinsurers that utilise collateralised reinsurance backed by ILS hold value in the diversification in counterparty risk achieved by rated collateral, and also the diversified base of capacity providers. Furthermore, there are trade-offs in risk spreads, preferences of the ease of process, non-spread costs, and post-closing flexibility concerns that also influence the choice of illiquid or liquid ILS, says WCMA.
However, “Innovation can reduce some of the relative advantage of illiquid ILS in the areas other than the risk spreads,” notes WCMA, explaining that initiatives such as the Resilience Re private ILS platform has already begun to mitigate the advantage of illiquid ILS.
“The next step in innovation is to close this gap further for the more liquid ILS while at the same time maintaining transparency and liquidity,” said WCMA.
“Of course innovation in illiquid ILS will continue too so it is by no means assured that innovation in liquid ILS will on its own shift the balance. Whatever the outcome, the clear winners are cedants and policyholders as innovation and broad growing interest from investors in ILS will benefit them by increasing capacity to share risks,” concludes WCMA.