This interview with Andrew Mawdsley, Head of Financial Stability and Information Unit, European Insurance and Occupational Pensions Authority (EIOPA), discusses the impact of the influx of capital into the ILS space and whether the market has become saturated.
This interview, fully titled ‘Has capital influx saturated the insurance-linked securities market and what should investors’ response be?‘ 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.’ Clear Path Analysis have kindly allowed Artemis to republish it here in full.
– Andrew Mawdsley, Head of Financial Stability and Information Unit, European Insurance and Occupational Pensions Authority (EIOPA).
– Jessica McGhie, Senior Publisher, Clear Path Analysis.
Jessica McGhie: How has capital influx impacted on the dynamics of the insurance-linked securities (ILS) sector?
Andrew Mawdsley: We’ve seen a welcome increase in reinsurance capacity reflecting the greater interest amongst investors to explore this area. There have been obvious effects such as the downward pressure on reinsurance pricing and I would say there have been clear waves of activity that have impacted the market.
The initial capital influx put significant pressure on reinsurers but they have responded with innovative methods for capturing the new capital that is entering the sector; including the increased use of sidecars to lever off their existing comparative advantage to sponsor ILS deals. Some traditional reinsurers have opened up asset management arms to be involved in ILS portfolio funds. The second welcome innovation is the increase in the issuance of instruments with indemnity features rather than an industry index trigger. Supervisors always have a fixation with the possibility for there to be a basis risk within these structures and to some degree, indemnity type instruments close that gap.
The final point I wish to make is with regards to investor appetite and the changes subsequent to this shift to indemnity instruments. Historically investors might have wanted the industry index linked securities to provide a clear picture as to what
their triggers and payouts would be, whereas now, investors are increasingly comfortable with insurance risks. That said, the question that remains for us is whether this changed appetite is permanent, as it has yet to be tested. These developments have largely emerged during the last two years where the loss experience has been pretty benign. It will be interesting to see what happens once this begins to change.
As supervisors, one of the things we focus on, in relation to the asset markets, is the extent to which there’s potential for a reversal of risk perceptions. In other asset markets such as high yielding corporate bonds, there has been very dramatic spread compression. Equally so, we have seen spread compression in ILS and therefore, we wonder whether this is due to a truly increased understanding of the risk, a perception that it has declined, or is it simply driven by the market’s search for yield. As supervisors we always cast a slightly dispassionate eye on new market developments and trends.
Jessica: Do you think the downward trend in pricing is a short-term blip or a new long-term market trend?
Andrew: It depends on how “sticky” this influx of funds might be, particularly when we consider that the market isn’t fully mature. We had a market that was growing dramatically, we had the crash, the market went very quiet and now we are seeing
the market start to grow again. In the context of broader asset markets where often yields on safer assets are very low, it’s hard to say yet if the developments are permanent and the jury is out on whether a reversal will happen.
Jessica: As this ‘alternative’ capital moves closer towards becoming a mainstream investment tool, are opportunities for returns becoming more or less feasible? To what extent has ‘saturation’ occurred?
Andrew: Saturation is a difficult concept to capture. When we talk about ILS becoming a more mainstream asset class then certainly investors have greater familiarity with it now. However, in the greater scheme of asset classes it still remains something of a minority interest because it is a fairly specialised asset class. In terms of the relative size of issuance versus the potential pool of investors, certainly there is growth potential because it’s not as constrained by the balance sheet from the investors’ side.
The question for us is around how realistic pricing is and whether it is based on a clear evaluation of risk or on the weight of money chasing these assets. There’s no guarantee that rates will remain as low as they currently are and there is an interesting feature here. If you track pricing evolution pre-crisis it appears fairly smooth, post crisis there are points of volatility that have occurred around loss events. This leads one to suspect a degree of sensitivity on the part of investors to loss events but until the market’s truly tested, this is hard to see.
Jessica: Are those pricing concerns shared by reinsurers?
Andrew: Hard to say because we approach it from a pan-European supervisory perspective and are consequently one step removed from what firms’ themselves think. We observe developments across multiple asset classes and consider ILS mainly in relation to the broader investment market and therefore, any concerns, are reflective of our overall asset market concerns.
Jessica: 2012 and 2013 were fairly benign for reinsurance losses but given that loss can occur in any given market, should there be broader participation in the reinsurance risk pool?
Andrew: The issue is always around whose perspective you’re looking at this from. From a reinsurers perspective I would argue that broadening the risk pool is very welcome, particularly if that pool is one of well informed investors who have a clear understanding of the risks they are taking on. Those investors understand that there can be a total loss with these instruments but equally, that they can get a strong return as a result.
However, if you look at it from the perspective of the investor you start to question what the risks are. Because unless you’re holding a diversified portfolio of ILS, you may face a very concentrated insurance risk related to that individual ILS. It cuts both ways and how people react to this depends on how informed they are as investors. The simple answer is yes, we certainly support a broader risk pool but the lessons of the past have to be taken into account.
One of my roles here is to look at the financial stability of the system as a whole and with a risk transfer of this nature, inter-linkages are created across the financial system. For a long time there was an argument that insurers were not systemically important because they were not so interlinked. Of course it is clear that the more issuance of these instruments we have, the greater the linkage becomes. It has to be remembered that it was the securitisation sector and the way that investors and issuers behaved within that market, which was really at the core of the crash. Those lessons have to be learned very clearly and therefore, a broad pool is only a welcome development if investors properly assess the risks and make well informed investment decisions.
Jessica: How can traditional reinsurers integrate capital better into new investment vehicles and what can they expect from the regulators?
Andrew: If you think about what comparative advantage a traditional reinsurer has there is nobody better, in terms of understanding reinsurance risks, than the manager of those risks, evaluating reinsurance deals and pricing them. So far reinsurers have tried to utilise this by sponsoring deals and diversifying their activity towards an asset management type of role, which of course moves them away from core reinsurance. Then there is also the use of sidecars which over the last few years have resulted in quite a lot of issuance, particularly on a global basis. Product design is another issue although perhaps that has become a little easier in some ways because of the increased appetite for indemnity type products amongst investors.
One of the key fixations that regulators have with regard to risk transfer methods, like securitisation, is its purpose. The number one issue revolves around whether risk is actually transferred and whether there really is mitigation that can be captured by the ceding insurer. This is very much embedded in the treatment of risk mitigation in Solvency II where there are qualitative criteria set down in terms of what’s to be expected in relation to contractual arrangements to improve the enforceability of risk transfer. Solvency II provides a much clearer framework across multiple jurisdictions with a more consistent and integrated approach to the supervisory treatment of risk transfer.
There is also the issue of the purpose behind the risk transfer. There are different ways that securitisation type instruments can be used and supervisors are much more comfortable when they see it used for actual risk transfer and balance sheet management rather than for funding; funding-type arrangements will always scrutinised much more closely by the supervisors.
The other issue is around the actual vehicles used to transfer risk so when we think about things like reinsurance, special purpose reinsurance vehicles (SPRVs) it’s very important that they are properly authorised and supervised. Investors and insurers have to be sure that when risk is transferred to an entity that is properly regulated, authorised and subject to solvency requirements that ensure there’s adequate capital within the system to support these sorts of risks. In reality the risk may go off the balance sheet of a given firm but it will still remain within the broader financial system. Therefore for regulators, it’s important that wherever it’s end destination is, there is appropriate capital there to support the risk.
Jessica: Thank you very much Andrew.
Read our other articles and transcripts taken from this report:
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.