The second in this series of articles, featuring the thoughts of leading figures in insurance-linked securities (ILS) and reinsurance on the market as we move into 2016, features Michael Stahel, Partner at LGT ILS Partners Ltd.
We asked for participants thoughts or predictions on the prospects for the ILS market, catastrophe bonds, collateralized reinsurance and reinsurance or catastrophe risks as an asset class in 2016.
Michael Stahel is a Partner at LGT ILS Partners Ltd., the ILS and reinsurance linked investment arm of private banking and asset management firm LGT Group.
He gave us his thoughts on how ILS might develop in 2016, including M&A, catastrophe bonds, and potential growth areas.
His response follows in full below:
The increased penetration of ILS and 3rd-party capital, where next?
We estimate the current size of the ILS capacity at roughly USD 70bn (26bn of which is in cat bond format). We are still seeing interest amongst institutional investors, especially pension funds, to allocate in the insurance-linked space.
The difference to previous years is that based on the current (lower) premium and return environment, such allocation is typically of strategic nature (long-term strategies allocation with the aim to capture the low correlation element of the asset class) rather than opportunistic (short-termed; focus on capturing attractive returns). Which ultimately results in a lower overall allocation within the investor’s strategic asset allocation, but given that a number of new investors are looking at ILS, we expect the market to show continued growth.
Such growth will most likely continue to be geared towards funds (typically open-ended) as such funds offer the highest level of transparency.
How do you expect the cat bond market to fare in 2016?
On the occasion of a recent US renewal trip, we have met with a number of insurance companies who, as part of their reinsurance purchase, also issue cat bonds. The general message was that the traditional and the collateralized reinsurance markets are currently perfectly able to provide sufficient protection and that cat bonds require a lot of management attention within an organization.
In addition, some cat bond sponsors have commented on the litigation risk that seems to be a bit of a topic for US insurers as they are facing many legal proceedings during the year with their actual consumer base.
Overall, the general mood regarding cat bond issuance is in our view fairly subdued; as a consequence, we expect that some of the cat bond sponsors will not renew their transactions as the bonds mature, especially the ‘one-off’ cat bond sponsors who may have seen the deal more as an R&D project and, based on the easy availability of cover in the present market environment may not necessarily renew – however, we also believe that especially repeat investors who have been issuing cat bonds to the capital market for many years will continue to emit their programs.
We therefore expect a deal flow for 2016 at unchanged to slightly lower volumes compared to 2015.
Any new lines of business or continued expansion into new lines you expect?
The current price environment in the pure catastrophe risk space has put pressure especially onto managers with return expectations between 12% and 18% (and above). This is exactly the rate-of-return area where the traditional reinsurance market (the ‘Bermuda-model’) has traditionally focused on.
ILS managers with such aggressive return targets (often managers driven by performance fees) as well as multi-strategy hedge funds with an allocation to ILS have heavily allocated to this area of return. The demand in this segment has meanwhile been met to a large degree and, as a consequence, such investors need to be prepared to assume higher risk levels, thereby reducing the actual net return (the multiple between risk and return) to a level where an allocation becomes less and less attractive.
As a result, we can see that such ‘high risk ILS managers’ have started to argue for an expansion of business lines beyond the catastrophe risk market towards ‘special lines’: Aviation, satellite, marine, offshore energy, casualty, terror and cyber risks to name but a few. LGT ILS’ view vis-à-vis going into such risks is clear:
- Firstly, there is a large degree of uncertainty around the risk assessment and consequently around the actual risk / return characteristics of such a ‘special lines’ transaction. Reinsurers address this uncertainty with many years of experience in the specific areas and in-depth knowledge of the contract clauses (mitigation of legal risk) as well as, rightly or wrongly, through cross-subsidies with other business lines (i.e. ‘relationship transactions’ whereby reinsurers supply protection for special lines in exchange for a large allocation on an attractive catastrophe risk book).
- Secondly, ILS funds with their pre-defined liquidity and valuation points are simply not made for assuming long-term risks where a loss event could potentially take decades to unwind and may come with substantial legal risk (as an example, the loss from the ‘Piper Alpha’ oil rig explosion in 1988 is still not fully settled).
In a nutshell, if reinsurers running leveraged balance sheets are not assuming such ‘special lines’ risks due to the risk / return characteristics, the question is whether this can ever be an area for ILS managers to become active.
Having said that, there may be new protection buyers for peak natural catastrophe risks: an area which may receive more attention is ‘mortgage insurance solutions’. What may initially sound like a revival of RMBS / ABS transactions that have been popular before the financial market crisis, has nothing with the latter and may in fact develop into an interesting new business area for ILS managers: increasingly, mortgage providers such as large banks or the large back-stop facilities Fannie Mae and Freddie Mac have started to realize that their portfolios are actually exposed to significant natural cat risks: if a large catastrophe event strikes and their mortgage clients are exposed to this events, there could potentially be a large level of defaults resulting from the rather low insurance penetration in certain parts of the world (the US, but also in Europe), particularly for earthquake risks. Residential mortgage holders may lose their house due to the cat event and absent of insurance coverage, there may not be any recovery resulting in a default on the mortgage. Especially once regulators start to include cat events into their stress testing of mortgage providers, this may provide an attractive investment opportunity for ILS managers.
Prospects for M&A (in reinsurance or between ILS fund managers)?
Our general view regarding the 2015 M&A activity and then the outlook for 2016 can be summarized as follows: The additional capacity from capital market investors is increasing the pressure on the traditional reinsurance model; capital markets capacity is allowing primary insurance companies to buy protection that is fully collateralized, thereby mitigating any potential counterparty credit risk. Large reinsurers (such as Swiss Re or Munich Re) are less exposed to this competition as they are underwriting a broadly diversified book of business and do not depend to the same extent on catastrophe risk premium income. Yet, especially the so-called mono-line reinsurers (the ‘Bermuda-model’) are under pressure as they see themselves exposed to competition which is capable of assuming large amounts of catastrophe risk in a lean and efficient manner, employing smaller and highly focused teams offering a quality of capacity which is unparalleled (due to the fully collateralized nature).
We therefore expect to see further M&A activity especially in the area of mid-sized reinsurers. As for ILS funds, we do not expect significant changes in ownerships. This is mostly owed to the fact that buying assets (buying ILS managers with a large asset base) is not desirable for large asset managers given that they would like to utilize their distribution power to raise assets (rather than pay for assets which are already invested). Yet the increased requirements from regulators will lead to smaller dedicated ILS managers trying to team up with larger companies to achieve some economics of scale on the operation aside (in the area of risk management, compliance, legal etc.).
Our thanks to Michael Stahel for his time.
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Artemis’ Q4 2015 Catastrophe Bond & ILS Market Report – Outright market growth continues
We’ve now published our Q4 2015 catastrophe bond & ILS market report.
This report reviews the catastrophe bond and insurance-linked securities (ILS) market at the end of the fourth-quarter of 2015, looking at the $1.525 billion of new risk capital issued and the composition of the cat bond & ILS transactions completed during Q4 2015. The report also includes a review of the full year 2015 issuance and commentary from co-editor GC Securities.