An accusation often leveled at investors in insurance-linked securities (ILS) is that they are “hot money,” in other words capital that is prone to flight and could exit the reinsurance market at any point, due to losses suffered or because there are better returns to be found.
Over the years Artemis has been tracking the ILS market there have been repeated accusations that investors in insurance-linked securities (ILS) funds and structures such as catastrophe bonds or reinsurance sidecars, are impermanent and cannot be relied upon to be there when the market needs them most.
Usually the subject of capital permanence, or otherwise, has been raised by traditional players in the market, so those most threatened by alternative capital and ILS, or by uninformed journalists from the mainstream media.
However, there is an increasing realisation that new capital from third-party investors and the ILS sector as a whole, is here to stay and increasingly likely to grow in size, rather than shrink away, when the next round of major catastrophe losses occur (which they no doubt will).
In its latest reinsurance renewals report, broker Guy Carpenter and its investment banking and capital markets arm GC Securities discuss the permanence and potential for ongoing growth of capital market investors direct participation in the re/insurance market.
And the broker believes that as the ILS market has developed the amount of so called “hot money” in it has declined.
“Participation from so called “hot money” investors has never been lower,” Guy Carpenter explains in the report.
When the ILS market first came into existence in the mid to late 1990’s there were many hedge fund and money managers participating who wanted to use the asset class as something they could trade in and out of.
Those who’ve followed the development of ILS will soon realise that the market has never quite got to this stage, of offering a liquid product that investors could trade into and out of rapidly, perhaps to be used as hedging against other asset classes. Despite a number of initiatives to bring about a trading market in insurance risk over the years, the ILS market remains largely a long-term horizon asset class and rightly so.
So the participation of hedge fund investors and other asset holders who would have been likely to come in and out of the ILS market depending on conditions and returns has been on the decline and Guy Carpenter believes the ILS market now contains the most permanent capital in its history.
This is good news for the ILS market, for ILS funds, for insurers and reinsurers who are ceding risk to ILS capital and also to investors in the space. Until an initiative develops a traded market in catastrophe options, or a tradable ILS exchange traded fund, this is likely for the best.
ILS needs investors with a long-term horizon, such as the pension funds who make up the bulk of the capital in the space now. These investors can take a multi-year view to returns from an asset class and can also apply a diversification benefit that enables them to ride out lower points in the cycle.
Guy Carpenter also said that investors using leverage has declined in ILS, saying; “Although some investors continue to use financial leverage, they were far more the exception than the rule. If financial leverage was used, it tended to be in small amounts.”
At the same time as ILS and alternative reinsurance capital is seemingly increasing in permanence it is remaining disciplined, the broker said. Pricing discipline, which originally became evident on the fourth-quarter of 2014, has continued through the first-half of this year.
“Recent deal pricing and investor feedback suggests that further catastrophe bond pricing reductions in the near-term would be unlikely,” the brokers report says.
As the reinsurance price declines accelerated through 2014 the spread over the risk-free rate offered by ILS and catastrophe bonds reduced, which as a consequence resulted in investors “questioning if price reductions leave them adequately compensated for the risk they are bearing.”
“Evidence of price discipline and thoughtful conversations between protection buyers and sellers about adequate compensation for risk should be welcomed by all market participants,” Guy Carpenter continued.
So here we have an asset class that over time is seeing less participation from investors considered to be “hot money” or less permanent, while at the same time the investors in the market are displaying discipline and a desire to ensure they are adequately compensated. Healthy signs for the ILS markets’ ongoing development, for sure.
Catastrophe insurance and reinsurance risk still provides these long-term investors with an attractive risk and return profile, which Guy Carpenter suggests means that “the asset class will continue to occupy an important strategic role in the investment portfolios of institutional investors.”
This despite the decline in returns, which has clearly been offset by an increasing realisation among investors that the asset class is here to stay, as they gain an appreciation for the low-correlated returns of catastrophe risk.
“Despite considerable spread reductions over the past 24 months, there are more investors participating in the asset class than ever,” Guy Carpenter said.