Complexity of ILS structures can create barrier to entry: Feig, CWT


The complexity of sophisticated insurance-linked security (ILS) structures has resulted in an intelligent and mature investor base, but the high entry barrier could also be hindering the growth potential of the marketplace, warns Matthew Feig, Special Counsel at law firm Cadwalader, Wickersham & Taft.

In an interview with Willis Capital Markets & Advisory (WCMA), the capital markets unit of insurance and reinsurance broker Willis Towers Watson (WTW), Feig, a lawyer experienced in the ILS space, discussed a Standard & Poor’s (S&P) report that concerns the ability and willingness of catastrophe bonds at paying claims.

Feig agrees with the S&P report, that cat bonds pay claims when triggered, and that ILS investors are highly sophisticated, suggesting they are unlikely to dispute claims, although the complexity of the marketplace could also be a hindrance to its growth, explains Feig.

“On some levels the institutional investor base is a simple reflection of that complexity and the specialized expertise needed to understand it, rather than just an arbitrary limitation.

“This has been a double edged sword in terms of expanding the market for issuance, new sponsors as well as new perils, but the high bar for entry has limited opportunities for other kinds of investors who might be more used to disputing claims,” said Feig.

So while the complexity of the catastrophe bond space has ensured that investors really understand the product and the risks being taken on, Feig feels that this could also be putting some investors off, ultimately hindering the growth potential of the market by indirectly excluding potential investors.

It is interesting though that Feig feels the high entry barrier can also have a positive effect, by ensuring that investors are sophisticated and ready to commit to understanding the sector which perhaps makes them more likely to stick around and also pay claims more responsibly.

So complexity can be beneficial to the market, by keeping the investor base sophisticated and committed, but can also hinder others from accessing the asset class.

The traditional 144A cat bond can be timely and costly to issue, and while the creation of the more streamlined, simpler, but smaller cat bond lite structure has gained some traction in more recent times, total cat bond growth has slowed in response to the challenging market environment, which has been more suited to collateralised reinsurance arrangements.

However, ILS investors appreciate liquidity and, increased liquidity also supports broader acceptance of the asset class as a viable liquid, alternative investment, something we’ve discussed previously at Artemis.

The more catastrophe bonds that are issued and in the outstanding market, the more liquidity there will be in the marketplace, and it’s likely that ILS investors prefer liquidity and diversification over a highly complex structure.

With barriers to enter the cat bond market considered quite high for sponsors, owing to the complexity of the product, the market could be putting off potential investors that would be willing and able to participate in the expansion of the space, were it faster, more efficient, and simpler to do so.

So despite the sophistication of the asset class ensuring the investor base is well-educated and mature in its approach to, and workings within the catastrophe bond space, it could be hindering the growth of the market and ultimately also reducing the liquidity of the ILS industry.

The catastrophe bond market does continue to grow, albeit at a slower pace than seen in previous years, and it’s clear that some institutional investors are more than happy with the marketplace in its current form, where they can achieve diversified, stable, uncorrelated returns that remain attractive when compared with other alternative asset classes.

However, innovation in the market to create simpler, more cost-efficient and liquid investments could help to stimulate increased demand for products from both existing, and importantly new investors, essentially helping the market to expand its reach and influence in the global risk transfer market.

As noted by Feig, investors in the ILS space “depend on a functioning, transparent, and liquid market for risk which means they will occasionally take losses.”

It’s been noted by a number of industry experts and observers that for the market to keep growing at the speed it’s been accustomed to in recent times, it will have to innovate in order to create new solutions for new peril regions, but the importance of establishing simpler, easier to access solutions for investors without losing the sophistication of the sector shouldn’t by underestimated as a potential growth driver.

“Precisely the fact that the market works well makes it ripe for innovation, and worthwhile investing in developing new products and incorporating new technology (blockchain, for example) which can drive growth but also increase efficiency and transparency. I don’t see major change as a test or a problem, but rather an opportunity to do what we do better,” said Feig.

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