Is the insurance-linked securities (ILS) market becoming less transparent, as transactions undertaken using capital market investor capital shift further towards the private and collateralized reinsurance arena, and what does this mean for investors and ceding companies?
ILS consultancy Lane Financial LLC attempt to shed some light on an ILS market they see as becoming increasingly opaque, in an article titled ‘Is the ILS transparency window clouding up?’ which was published on Friday in the firm’s latest market report (which you can find here).
Insurance-linked securities (ILS) and catastrophe bonds came into being as the traditional insurance and reinsurance market realised that for certain peak exposures the depth and liquidity of the capital market was seen as an ideal home for the risk.
Institutional investors were willing to assume and hold these risks, in return for a premium, and the market would have secondary liquidity, meaning price transparency would be key and risks would be priced according to market supply and demand factors, as well as risk appetite and understanding.
An ideal solution to the catastrophe risks of the world and one which has seen the ILS market grow to become a truly meaningful proportion of overall reinsurance capital.
But as the market has grown, the idea of liquidity and transparency has lessened, as the market has shifted in favour of more private transactions and fully collateralized reinsurance deals.
This has connotations for the ILS market, in terms of raising barriers to entry, limiting liquidity of the risk traded, making valuations more difficult and marks much wider.
Lane Financial LLC’s Morton Lane, President and Roger Beckwith, Vice President, explain in the article that their position was that transparency is good for the reinsurance market and that ILS would help to promote and provide greater transparency.
In the early days ILS certainly did that and continues to, particularly in the catastrophe bond market where liquidity has picked up gradually and there is certainly some more transparency available today thanks to the Trace system from FINRA.
However, overall in ILS and collateralized reinsurance, so the area of the reinsurance market where the capital markets backs the risk and it is generally securitized in some form to get into a hedge fund style portfolio of investments, the proportion of the assets that include some transparency has lessened.
The reinsurance market generally has more transparency in it and this includes collateralized reinsurance, Lane Financial explains, with more people understanding risks, understanding the chances of placing them and the rough pricing marks.
But as reinsurance transparency has increased slightly, overall ILS transparency at least from the perspective of an outsider such as a new interested investor or ceding company, has decreased.
There are those in the market who live off less transparency, as the edge this can give enables them to command a kind of alpha from their investors or counterparties. Controlling the flow of information in risk transfer markets can be vital to certain business models, resulting in mixed messages on transparency and conflicting motives sometimes.
“This tension between transparency and opaqueness is true of all markets,” Lane Financial write, explaining how other capital markets which can appear transparent are sometimes more opaque than they seem.
But in ILS the price transparency of the market has been decreasing, according to Lane Financial, with fewer pricing marks published, while some quote wide markets for bonds.
“More and tighter prices is better for transparency and better for meaningful analysis,” the article states, with this benefiting both experienced market participants as well as those tempted to participate on the investor or cedent side.
Industry loss warranty (ILW) pricing too is “increasingly rare and less reliable” Lane Financial note. In our experience the ILW pricing sheets we see are rarely the prices that deals can get done by and are rather more ‘directional’ than a true indicator of market appetite to assume risk at a price.
But still, these marks did provide an indicator for investors, funds, and potential counterparties, which were valuable and the more widely distributed the more value that created, in terms of increasing market deal-flow and liquidity.
Sadly though, there are some again who feel that broadly distributed pricing reduces their value-proposition to the market, as price marks tend to converge on a market-level pricing, which for intermediaries can remove their ability to leverage price as a differentiator.
As transparency declines, as a proportion of the overall ILS and collateralized reinsurance market, Lane Financial warns that this has connotations that the market and its investors should be aware of.
ILS pricing sheets for catastrophe bonds and more broadly syndicated deals are often used as an input to ILS valuations, including the valuation process for setting monthly marks on collateralized reinsurance deals.
“If the ILS market is now 30% of the combined alternative market and the CR (collateralized reinsurance) market is priced off the visible ILS market it should send up warning flags,” Lane Financial cautions.
As ILS funds have to provide monthly marks for their investors, inputs such as pricing indicators are valuable to ensure more accuracy.
“The more that is based on a smaller and smaller ILS market the less credible is the overall valuation,” the article warns.
As ever, Lane and Beckwith offer some food for thought in their latest report and these issues of transparency are important.
Many catastrophe bond sponsors appreciate the transparency that the market has, and it can help them in their traditional reinsurance placement as well, where transparency is lacking.
For investors too, the availability of transparency is key and can be a significant driver of first-time and new allocations. Without a level of pricing transparency it is very hard to understand whether an ILS fund is valuing well or accurately and while investors should be able to trust their ILS manager on this, having some third-party validation is extremely important for stimulating further market penetration and growth.
When it comes to transparency in ILS it’s also important to consider standardisation as well, as this is one of the main reasons transparency has lessened.
As sponsors and ceding companies look for ILS products to more closely mirror traditional reinsurance, the move towards indemnity triggers, more complex terms and reinsurance contract features, have all meant that its harder to price and value transactions and there is often less overall transparency in the deal.
If the ILS market were more standardised, based more on parametric triggers and indices, the level of price transparency would likely rise.
But once you have broader standardisation and transparency you also encounter the issues around roles in the market, as a truly standardised ILS market would be far better transacted electronically on an exchange than privately through brokers.
An ideal scenario might be that, say, 50% of the world’s catastrophe reinsurance was a standardised, hedging type product, using parametric triggers and indices, traded and placed electronically, while the rest was more customised and designed to fit the cedents needs.
The larger transparent portion would help buyers be more efficient, better understanding their needs on the customised side, while also allowing brokers and underwriters to really put their expertise to work in meeting the needs of clients risk transfer requirements, while the client can largely arrange the more standard coverage themselves.
The level of price transparency that such an exchange traded environment might generate would be significant, truly enabling a price to be put on catastrophe risk at any one point in time.
The insight and liquidity that would provide to the market would be significant and helpful to the majority of participants.
Could we see a day where a significant proportion of global catastrophe risk transfer is electronically traded? We believe it’s likely one day, perhaps in the not too distant future when you consider the number of insurance technology (Insurtech) start-ups looking at this space.
That could provide all the transparency that ILS markets, cedents and investors could need.