Swiss Re Insurance-Linked Fund Management

Original Risk: A Society for Change Agents

Lack of issuance seen as potential reinvestment risk in ILS


The pace of issuance of new catastrophe bonds and insurance-linked securities (ILS) continues to be seen as a risk to some asset and fund managers, who see the reinsurance asset class as an attractive complement to their portfolios but worry about issuance volume.

Increasingly traditional asset managers are discovering, learning about and gaining an appreciation for ILS, reinsurance and catastrophe risks as an asset class. That is leading more of them to want to invest in ILS and catastrophe bonds, but the pace of issuance is seen as an issue.

Over the last few years insurance-linked securities (ILS) and catastrophe bonds have featured more and more in asset managers SEC filings. For ILS and other event linked securities to feature in the list of acceptable assets that traditional asset managers can allocate to is no longer an unusual occurrence.

They are now seen as viable and attractive assets that many traditional multi-asset class investment fund managers would like to be able to add into their portfolio mix.

But the level of issuance makes adding ILS into a multi-asset class portfolio potentially risky, according to some of these managers. It’s now not unusual to see language explicitly citing “market risk” and “reinvestment risk” associated with ILS, catastrophe bonds and reinsurance linked investments, in asset manager fund filings submitted to the SEC.

As the ILS market can fluctuate in size and also go through periods with no issuance at all, such as through the hurricane season, some more traditional investment fund managers see this as a risk. Issuance is not just a factor of the demand for protection, but also of available capital from investors.

At the same time the secondary market responds to more than just trading patterns or volumes and the occurrence of catastrophe events. It is also affected by primary issuance, available capital, demand for diversification from investors, other supply and demand dynamics as well as broader economic factors.

As a result it can be difficult for fund managers to be as fully-vested as they would like to be in the asset class, having to maintain cash or short-term investment holdings in case of any redemptions.

The reason for this is that should a multi-asset class fund be required to return capital to investors, for redemption or share repurchases, it would typically seek to sell down assets at an even pace to maintain diversification within the portfolio.

ILS assets are subject to the supply and demand economics that can make selling positions difficult at times, or less cost-effective, due to secondary price declines as has been seen in recent months.

Or perhaps an asset is particularly illiquid, making its sale on the secondary market very difficult, again asset managers need to be able to accommodate investors redemption requests and so getting into ILS can mean holding more cash as well.

The other issue can be around deploying capital. If an asset manager adds an ILS allocation into a multi-asset class fund strategy they will likely aim to keep the allocation to a certain percentage of total assets.

So that means when they raise new money some of it needs to be deployed into ILS, the ability to achieve this will of course be dependent on what is available in the primary or secondary market at that particular point in time.

Again, this can result in cash being held and diluting portfolio performance, although for the opposite reason, an inability to easily deploy capital rather than a desire to maintain a level of liquidity for redemptions.

The problem here isn’t the asset class itself, rather it’s a function of the high levels of demand still not being met by issuance. While the market satisfies many investors and the growth of ILS is held back by global reinsurance market demand to a degree, it has always been felt that issuance could be higher given the growing demand.

Investment managers are looking to allocate to ILS and reinsurance right now, but the fact that issuance can be slow at times and tails off completely during hurricane season is causing some of them to state these risks in their prospectuses.

While liquidity and issuance can be seen as a risk by larger, more generalised asset managers, the specialist ILS managers in the sector do not have the exact same issues, although reinvestment risk could rear its head after deals mature.

When a year, or multi-year, reinsurance or catastrophe bond contract matures with no losses, the ILS manager wants the collateral released as quickly as possible so it can be reinvested. Problems could arise here if the deal matures outside of the traditional reinsurance renewal cycle, making finding a new home for the money more difficult.

This issue faced by ILS managers and specialist reinsurance fund managers could be eased in future, as increasingly there are opportunities to deploy capacity outside of the renewal cycle. As reinsurance capital efficiency increases these opportunities may increase as well, making opportunities to underwrite new risks available throughout the year.

Perhaps where reinvestment risk is at its greatest is for any UCITS or mutual funds that have strict mandates about cash positions in their portfolios. This can put the onus on the manager to deploy capacity, perhaps increasing the temptation to put it to work in less attractive transactions.

So, reinvestment risk, an issue for some of those who invest in ILS and reinsurance and one that seemingly won’t go away until either issuance ramps up enough to meet demand, or the renewal cycle dies and issuance and renewals occur right the way throughout the year.

It cannot be denied that if the market could double issuance of catastrophe bonds, the investment capital required to support that issuance level would likely be found by the specialist ILS managers and pension funds of the world.

The question then might be, how much is enough to really satisfy demand?

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