The fact insurance-linked securities (ILS) and catastrophe bond issuance follows the traditional reinsurance renewal cycle might hinder the development of the market, as some investors would prefer a steady stream of issuance throughout the year.
This is according to an interview with ILS market investors Charles Melchreit and Chin Liu of Pioneer Investments, featured in global independent insurance manager and provider of risk transfer solutions, Kane Group’s, latest ILS inSights publication (available here).
“In order to make it a more credible asset class for the wider investment community, changes to the issuance calendar would be a big help,” advised Melchreit.
This raises a valid point, as typically large volumes of issuance occur at the start of the year, around June/July and then towards the year’s end, with significantly less transactions taking place between the traditional reinsurance renewals.
“This is an impediment to the development of the market for fixed income or equity investors,” continued Melchreit.
Increasingly, more traditional fixed income type investors are attracted to ILS and reinsurance securities, but for these, sometimes very large investors, the ability to deploy capital throughout the year would be preferred.
Fundamental changes to the reinsurance market are expected over the next ten years, something we discussed recently here at Artemis.
But so far much of the talk has surrounded the longevity and impact of the abundance of third-party capital currently flooding the market, with little discussion circulating around issuance trends. The Pioneer investors went on to discuss where the ILS model could be improved.
In the interview with Kane, Melchreit stressed that despite the issuance calendar highlighting a concern within the market, “it is testament to the successful development of the ILS space and the structures within it that in terms of how it could be improved we are only talking about potential refinements rather than major changes.”
And for Chin Liu, the “biggest change that needs to take place is greater standardization. We need to look at how to better commoditize reinsurance.”
He continued to explain that a lack of standardized documentation processes and a failure to successfully standardize risk definitions, leads to inefficiencies and increased overheads when completing deals.
Transaction efficiency can be greatly boosted by risk transfer platforms like the Kane SAC note program, adds Liu, saying; “Greater acceptance of such platforms by the wider investment community will be a significant step forward.”
Reflecting on the reinsurance and ILS markets performance and structure over the last 12 months or so, evidence of change can already be seen.
Investors are increasingly accepting aggregate deals and also show a clear shift away from predominately favouring single-peril deals, with multi-peril transactions becoming more commonplace.
Liu expands on this point; “In my view, current market dynamics are characterized by this increased willingness to accept aggregate structures, coupled with a very aggressive pricing environment.”
The ILS market’s willingness to accept aggregate structures also benefits cedents, Melchreit explained; “From a sponsor’s perspective unsurprisingly the current very attractive pricing environment is seeing them pushing to lock this in for the longer term.”
Pricing pressures remain in the re/insurance market and the general consensus is that a floor will eventually be established as the market continues to soften.
But Melchreit claims that the rising use of multi-peril structures offers some much-needed and welcomed diversification to investors, for which they are more inclined to pay a higher price for. “Increasingly, we are witnessing smaller diversifying risks being included in larger transactions,” he explained.
“We would expect to see a greater willingness on the part of investors to accept a lower yield in return for greater diversification,” confirmed Liu.
And a trend is emerging where investors are willing to give more away on price for the portfolio benefits offered by a deal; “There is certainly a degree of polarization happening in the market. For the high yield, high loss potential deals we are still seeing investors willing to pursue these aggressively. However, on what we would describe as the more remote perils, these seem to have hit something of a pricing floor and we would expect to see a further flattening of the yield curve on these,” Melchreit said.
Looking ahead the investors from Pioneer said they expect to see interest in diversification increase, as the market remains overly exposed to U.S. peak zone risks.
“We would expect to see a greater willingness on the part of investors to accept a lower yield in return for greater diversification. However, it is important to note that cedants cannot simply look to place poorly performing risks into these programs – investors will demand that these diversifying risks be rigorously defined,” Liu explained.
The pressures and stress surrounding the global reinsurance space are beginning to reshape the traditional business model, leading to consolidation and aggressive pricing strategies.
The pricing trend is expected to continue, according to these investors, and Liu said that while catastrophe bonds have tended to reward investors in the past, “We don’t expect to see that double digit level of return continuing.”
Melchreit qualified this, adding that the asset class still offers value to investors; “Even if we are seeing reduced returns, the diversification benefits the ILS arena offers investors still more than compensates for this.”
Liu agreed, saying; “While the potential returns are showing some decline, compared with competing asset classes such as high yield bonds or bank notes the ILS sector is extremely competitive. It remains particularly attractive to investors when compared to opportunities in other asset classes.”
But as the investors from Pioneer discussed, this isn’t necessarily a bad thing and invites the opportunity for innovation and progressive, positive structural change, whether this be a change with the issuance calendar or improved standardization.
On what could cause the market to change direction, Melchreit said; “There is an argument to be made for some investors turning tail and exiting the market following a major event.”
However, Pioneer would not expect the majority of investors to exit the market after a large catastrophe loss, Melchreit explained; “Our view, however, is that the capital in the market today is smart capital – investors are aware of the risks and are appropriately diversified.”
There is already some evidence that more opportunities to deploy capital into new reinsurance deals are available between the major renewal periods now, recent reports suggest a number of opportunities taken up by some ILS managers in February and March.
With catastrophe bonds, the lull during the U.S. wind season is perhaps the biggest issue, as issuance can all but dry up at that time of year. If more diversifying perils can be brought to market through the summer months, providing investors with new capital deployment opportunities, it could result in more investors being attracted to the space.
For some of the fixed income or private equity type investors that have become aware of ILS as an asset class, it is important to see that the market will support their portfolio needs with a regular supply of new securities to invest in.