With the growth of the collateralized reinsurance and insurance-linked securities (ILS) market continuing apace, at a time when broader financial markets and the investment environment can be challenging, it is vital to consider how collateral pools for ILS transactions are managed and allocated.
When looking at current conditions within the short-term debt and money markets, the picture has been rather bleak for some time. Challenges have included yields for money market securities at persistently low levels across most developed markets and falling into negative territory in the Eurozone. At the same time, regulations such as Basel III and Solvency II are creating a supply / demand imbalance for short term High Quality Liquid Assets (HQLAs) and altering the deposit-taking appetite from banks.
Diverging central bank policy has created additional uncertainty for investors in HQLAs globally. In the U.S. the Federal Reserve (“the Fed”) has started the process removing accommodative monetary policy by ending the Quantitative Easing (QE) program in 2014. The timing of an actual rate increase is expected to happen later in 2015.
A move higher in the Federal Funds rate would provide some much needed relief at the short-end of the yield curve for many dollar-issued securities. Meanwhile, rates in short-dated EUR securities and sovereign paper are becoming ever more challenging.
These conditions are expected to continue in Europe, with the ECB providing additional accommodation following their recent announcement of Quantitative Easing in January (2015).
As these cash markets have evolved, so has the reinsurance industry. The growth of alternative funding sources in collateralized reinsurance and insurance-linked securities (ILS) with capital market investors has resulted in the existence of significant collateral pools in order to reduce the correlation of the investment to traditional credit or equity investments. However, the management of collateral pools is becoming more of an issue due to the aforementioned factors.
The daily demands of managing the collateral are increasingly time consuming and complex. Cash typically will represent a large component of these collateral considerations. The securitization of liabilities within the capital markets, or through the formation of sidecars can look for cash used for credit enhancements to be invested within money market funds (MMFs). Specifically, Treasury-only MMFs fill this role nicely as they meet the credit objective of perceived zero to very low risk.
Increasingly over the past several years, BlackRock Cash Management has been called upon as a solution provider within collateral pools. The use of our money market funds across these structures fits the need for having a low-risk option where the collateral can be held and called upon with same-day liquidity. The primary objectives of our Triple-A rated money market funds are capital preservation and liquidity, followed by yield.
Taking a closer look at the options in this space, there are a few considerations to be made: domicile of the reinsurance structure will often determine the domicile of the money market fund to be used. Traditionally, those structures with offshore domiciles will use an offshore money market fund to avoid withholding tax treatment on the distributions made by the Fund.
However, the American Jobs Creation Act of 2004 (or “Jobs Act”) has introduced some ambiguity here. This act has received extensions several times over the past several years, and most recently has been extended by the newly-enacted Tax Increase Prevention Act of 2014 (the “Act).
The Act permits a regulated investment company to designate distributions of qualified interest income and short-term capital gains as exempt from U.S. withholding tax when paid to non-U.S. shareholders with certain documentation. Ultimately, this has meant that non-U.S. entities have been able to invest in onshore funds over the past several years without penalty of adverse tax treatment over the income generated from those investments.
As a result, we at BlackRock have seen a good split between ILS / Cat-bonds being invested in our onshore U.S. Treasury money market funds and our offshore U.S. Treasury MMFs. It is worth noting that there is no way of knowing if this Act will continue to be extended or will sunset in any given year. As it stands now, it is due to sunset again this year.
Another consideration is the currency of the structure. Within USD, which is the base currency for the large majority of the collateralized reinsurance market, a further distinction between Treasury-only and Treasury + Repo funds can be made. Additionally, if there is to be a trend this year to increased issuance within the European collateralized reinsurance markets, money market funds within the base currencies of Euro and /or Sterling may be required for these collateral pools.
BlackRock Cash Management is able to offer money market funds as solutions across each of these categories: both onshore and offshore Treasury-only and Treasury-repo funds are available across US Dollar, Euro and Sterling currencies which would be suitable for the collateral in these structures.
Although it is most common for Treasury or Government money market funds to be used for the collateral in this space, it is not mandated. Prime money market funds can also be utilized and again BlackRock Cash Management has both onshore and offshore options available in this space across USD, EUR, and GBP.
There are a number of factors at work affecting the cash markets and as the collateralized reinsurance market continues to grow, an added emphasis will need to be put on how the collateral pools will be managed. With the challenges currently facing the short-term debt markets, money market funds continue to be an ideal solution for this collateral in providing safety and liquidity.
This article is sponsored by BlackRock Cash Management.
|Danielle Nefouse, CFA,
BlackRock US Cash Sales
+1 212 810 8408
BlackRock International Cash Sales
+44 207 743 1105