Research firm Clear Path Analysis kindly asked Artemis’ editor Steve Evans to moderate a round-table discussion for its most recent report, Insurance-Linked Securities for Institutional Investors 2013. The report which we covered in more detail here looks at the insurance-linked securities, catastrophe bonds and collateralized reinsurance sectors and discusses how the market has evolved.
The round-table titled ‘Examining the drivers behind recent insurance-linked securities transactions and how the insurance-linked securities sector is evolving’ features four ILS sector experts, with perspectives from the structuring, administration, investment and fund management sides of the marketplace.
The round-table featured:
- Chris Parry, Director and Head of International Capital Markets, Aon Benfield Securities.
- Liz Frederick, Director of ILS Insurance Management, Aon Captive & Insurance Management.
- Dirk Lohmann, Managing Partner and Chairman, Secquaero Advisors.
- Philippe Trahan, Director, Insurance-Linked Securities, Ontario Teachers’ Pension Plan.
The full transcript of the round-table follows below.
Examining the drivers behind recent insurance-linked securities transactions and how the insurance-linked securities sector is evolving
Steve Evans: How do you feel 2012 compared to previous years in terms of number of transactions?
Chris Parry: Last year was an exceptional year, and the second highest year on record for catastrophe (cat) bond issuance. We are still lagging behind the 2007 high but the market is currently taking a step forward and we are seeing a wave of new issuances come to market. The market is still dominated by repeat issuers so in order to facilitate growth; we need to encourage new sponsors to use the ILS market. In terms of numbers, there were 26 cat bonds issued and 3 new sponsors came to the market last year.
Dirk Lohmann: What I found encouraging were some of the new elements in the market such as the introduction and use of aggregate type covers where they were covering either a frequency of major events such as hurricane and earthquakes or smaller events like tornadoes. After the unfortunate experience we had with the Mariah Re bonds, it was encouraging to see that these elements came back and the structuring also seemed to be a bit better on some of these deals.
Steve: Were there any ILS transactions in 2012 that particularly stood out for you? If so, why?
Chris: We are currently observing a shift from industry loss triggers to indemnity. Most sponsors that come to market are primary insurance companies hedging their U.S exposure. 70% of the exposure in the ILS market covers U.S hurricane and U.S earthquake. So it is good to see more indemnity type transactions coming to the market. The more indemnity type transactions that are successful ILS the more likely it will help facilitate growth for some of the smaller sponsors who are less comfortable taking on basis risk.
Dirk: I see indemnity making ILS an attractive source of capacity for sponsors, particularly primary insurance companies. It is a welcome alternative as many were clearly uncomfortable with the basis risk. When you go beyond some of the more intensively modelled markets such as the U.S, the issue that presents itself is how well the models actually reflect reality, how much confidence can you place in them when it comes to pricing, how much model risk are we actually picking up as investors? With respect to certain geographies, it is probably bigger than many people appreciate. The flip side to this is that there isn’t very much in the way of index providers out there other than perils right now, which is doing a good job, but is still limited in its geographical scope. There are other areas which could use it too.
Philippe Trahan: In terms of specific transactions, Everglades Re was one of the banner transactions of the year because of its size and because of its ability to enlarge the number and type of investors, notably due to the high spread. Another interesting transaction was Kibou which occurred very early in 2012 after the Japanese earthquake following the revelations that the Japanese earthquake models were glaringly wrong and that they had completely underappreciated the likelihood of such a significant event in that fault line. Kibou was a cat bond structured on a parametric basis and that included 2 or 3 more pages of disclosure specifically reminding investors that the model used for Kibou was the same as the one used prior to Tohoku that was deficient, so buyers beware. Yet, this deal was heavily subscribed and was well received by the ILS community at large.
We talk of 2012 as being a banner year but we forget that the first quarter was very hard as two large investors effectively disappeared for a little while to sort out various internal issues, and there was a time when a few deals had to be pre-marketed under non-disclosure agreements to get done. There was a time when the viability of 2012 and the large pipeline of issuances which lay ahead came under question because the capital was suddenly no longer there to be deployed. Notably were the IBIS Re and Mystic Re deals which required significant efforts to get the deal done. From there, things started to change with the large investors returning to the market, new capital flowing in and the year ended up being a great one. Although the sponsors may have paid a higher price for those deals, their commitment to getting these deals through certainly helped the market get much better afterwards.
Liz Frederick: What I found intriguing was the increased number of state-backed insurers that have come to market recently. From an administrator’s perspective, it is always interesting to see what areas of the industry are attracted to the ILS market and who utilises the products. Based on market analysis with the Everglades Re transaction, it seemed to increase interest across the industry which is good because it will hopefully lead to further new cedants entering the market.
Steve: Philippe, thinking back to when you first entered the ILS sector, what were some of the drivers behind your decision to allocate to ILS?
Philippe: When we first allocated in 2005, I was not working for Ontario Teachers’ Pension Plan (OTPP). But, I believe the main drivers for my colleagues were the very opportunistic nature of the investment at the time. In the aftermath of the hurricane season in 2004-2005 with rates being where they were, there was significant distress and dislocation. That itself merited an investment in that market for OTPP, although we subsequently reflected and spent more time understanding the space in 2006 and its key drivers in order to develop a more formal and permanent ILS investment strategy. The diversifying nature of ILS, the lack of correlation as well as the positive expected rate of return that the asset class offered where the three key drivers that influenced us to become part of this market.
Steve: Are the drivers for increasing exposure, or entering the ILS space, different today than they were before?
Chris: There are a number of reservations that people have when coming into the market. Within the European reinsurance market, there is a plentiful supply of capacity and as such, pricing is very competitive on the traditional side. So it is very difficult to encourage sponsors or reinsurers to access the market when they have full coverage on an all natural perils basis. This compares to a cat bond where you potentially have inherent basis risk within the structure, along with additional frictional costs.
We will overcome these challenges as people become more comfortable with the capital markets and the association with third party capital. It is very much an educational process to get people comfortable with the structures and costs associated with accessing the market. But it is certainly going to move forward if prices continue to come down as we are seeing at the moment.
Dirk: From an investor’s perspective, the motivations for entering the space are not materially different from what they were when people originally entered. I recall in 1994 when I was trying to place a deal on behalf of Hannover Re that we were arguing about the low correlation and the positive returns on an absolute basis. These issues are still here now, but the enhanced interest amongst institutional investors shows that the product has matured. The low correlation was proven when the asset class came through well in the crisis back in 2008 and with the Tohoku earthquake. The fact that a bond had a loss was in a way positive in that people saw that this does happen, but it also showed the lack of correlation within the asset class. The diversification that exists within the asset class was proven because you saw the one bond go down to zero, but U.S wind bonds which were not affected at all. From this standpoint, it helped many institutional who were sitting on the sidelines to get a better understanding and feeling for this market place.
With the growing issuance, along with more liquidity, it gives them some comfort. Although, the real issue and challenge is that the size of the market is still very small and many of the investors are choosing to pursue a strategy which is a combination of bonds and private placements, with collateralised insurance because they won’t be able to get the exposure that they want for it to be meaningful for their allocations.
Philippe: The reasons which led us to invest in this space remain very valid today. The distress and dislocation are gone but the key themes of diversification, lack of correlation and positive expected rate of return are all still there. Low yields in the broader capital markets are helpful now in further attracting capital to ILS, although some of it might not stick around when those yields start going back up.
Steve: How have transactions changed given influential factors such as recent trigger events, supply and demand issues, etc?
Chris: I mentioned previously the move from industry loss to indemnity, and this is one of the major changes that we have seen. The third party capital flowing into the market is changing the dynamic within the market. At the moment, issuance is focused on peak perils due to the reliance on credible modelling but again, we really do need to see ILS competing with the traditional markets and be more open to risks such as South African or New Zealand earthquakes, etc. If we can bring these types of risks to the capital market, it will lead to greater longevity for the market and sponsors will also get greater confidence in that the market will be able to support them beyond just the peak territories.
Philippe: With the tight conditions that prevailed in early 2012, we saw improvements in the products from an investor’s standpoint. This meant better exposures with the modelling agents starting to provide the raw data files as part of the transaction, better governance on the board of the special purpose vehicles (SPVs) as well as better reporting agent agreements which altogether helped avoid ambiguous situations such as the one that might have arisen on Mariah bonds. Now that substantial capital has come into the market, we’re witnessing a softening environment which bears all the classic signs, such as price reduction, the terms and conditions are getting wider, longer durations, increasing capacity offered for aggregate , use of franchise deductible over straight deductible, etc.
Liz: We have seen a lot of changes from a practical perspective in terms of how the transactions are managed. There has certainly been an increase in transparency and information available to note holders, both pre-transaction and post close of the transaction. Investors are provided with a lot more documentation throughout the life of the transaction which assists them with their investment decisions and with monitoring the investment after the initial purchase. Additionally, we have seen an increased focus on the credentials of the service providers who play a role post-close, including the Administrators, Claims Reviewers, Loss Reserve Specialists and Calculation Agents.
A while back, the primary focus was on the cedant and the risk covered in the transaction but, over the last 3-5 years with the number of bonds that have been triggered, this has changed. There has been an increased focus on the experience and expertise of who is managing that risk after the vehicle is set up and how it is going to be managed. Separately, there has been an increased focus on who are the service providers that determine whether there has been a loss, if there is a loss, to what extent has there been a loss, and what size payment is going to be made. Due to recent events, there is a heightened awareness of who these partners are and what they bring to the table in these types of situations.
Steve: What have been the most popular ILS investment vehicles recently and why do you feel this is the case?
Dirk: If you look at aggregate volumes of assets managed, I would say that the most popular are funds that are investing in a full range of catastrophe related risk. This means that they would buy bonds, collateralised reinsurance, ILWs, swaps, etc. and the background behind this is that the cat bond market itself is still very small and although it has grown, it’s still around $16 billion and is half of the total cat capacity that is actually placed with the capital markets.
Philippe: The most popular vehicles are the ones that offer a wide range of products and not just cat bonds. It may be that liquidity is not a significant concern as the cost of illiquidity in todays market is very low. In some ways, if you are chasing yield, it can be easier to enter into investments with retro sidecars or vehicles that are managed by reinsurers than simply buying cat bonds.
There is a natural limit to the cat bond market and I feel that you still get much more transparency, control and better insight into what you are assuming through a collateralised reinsurance product. The bond market has its own dynamics and is not as smooth perhaps as collateralised insurance might be and so it makes sense to be invested in a strategy that can be flexible, fluid and allow you to go longer a product, shorter with another one or vice versa. This flexibility and the cat bond market constraints explain why we have seen the growth of investment and inflows really going into funds that offer that wide range of products.
Chris: It is important to bear in mind the return expectations that investors have, this will certainly dictate their investment decisions. A 4-6% return for pension funds would typically meet their expectations and especially when comparing the return to other asset classes. If an investor is trying to take advantage of a post-event situation, this is where a sidecar can come into its own and then an investor will be looking for higher returns such as a hedge fund or private equity firm who will be positioning themselves to take advantage of a hardening market. This later dynamic has changed recently and we are now seeing more portfolio securitisations which can be seen to meet strategic objectives for reinsurer companies. The return threshold is the key metric and a key determinant over which type of vehicle someone might choose to invest in.
Steve: Where do you see the applications for ILS outside of the peak catastrophe risk?
Chris: We are looking at a number of different areas; one area we are currently looking at is providing solutions for offshore energy. There is an opportunity to broaden away from your typical peak areas and we are looking at a number of different formats to do this. It is a new exploratory product but we are hoping that this type of product will take off and appeal to a broader range of investors.
Philippe: I’m happy with peak risk only as ILS only represents a small percentage of OTPP’s overall capital deployment so we don’t need to diversify further. We find that chasing diversification just creates even more overlap and head-to-head competition with traditional reinsurers. Remember 2011.
Dirk: There are a number of applications outside the cat risk, but the return expectations attached to these will have to be different. An example of this is the Vitality Re transaction. Aetna’s motivation for this is that there is some risk transfer but the principal idea was to rationalise its capital structure and to lower its overall cost of capital. This is done very effectively and could potentially be an attractive type of instrument for insurers seeking to optimise their overall capital structure. There could also be significant activity in using ILS for life embedded value financing.
There have been some large ticket transactions done in Europe recently for around €600 million which were done by the likes of SCOR or Berkshire Hathaway. These transactions have interesting cash flow characteristics which could be very attractive for investors. The key issue here is that the duration of these instruments is much longer so there isn’t the same degree of liquidity and this is going to be a challenge for many investors.
Steve: How is the ILS sector as a whole likely to evolve over the next 2 to 3 years?
Liz: I believe there will be continued interest in how to balance transparency and liquidity in all ILS products. The transactions will continue to provide enhanced disclosures and accessibility to information to ensure that investors are comfortable with how the trigger events play out. As Administrators, we continue to look for ways to make the process smoother, thereby enhancing cedant’s and investor’s confidence in the vehicles, and bringing more parties to the market.
Dirk: It is a function of what happens with interest rates and alternatives to this high yield instrument as this is one of the few that generates a positive return. If market rates stay very low, you will see a very rapid expansion in this sector. If all the other alternatives come back, the speed of growth may slow down because it is still a novel thing and for many allocators, there are a lot of unknowns involved. This is one of the biggest elements that will determine how quickly this sector grows and the other issue is how quickly we get new products into the market.
Chris: The comparable asset return is a key issue so whenever we look at this, one of the key questions we are asked is whether pension funds’ money is sticky money i.e. will it continue to support sponsors post event? The view is that they have taken significant time to research the asset class so there is a good chance the funds will now be a long term fixture of the market. It’ll be interesting if the returns for other asset classes return to normal. Will there be an outflow of capital? In addition, with the recent reduction in risk premiums on primary issuances, this should lead to additional interest from first time sponsors and also a broadening of coverage to non-peak perils. More products/sponsors is the key for the growth in the market.
Philippe: I do hope that OTPP want to stay in the ILS sector! The notion of yields and where they go compared to returns is very important although perhaps slightly less applicable to pension funds. No one has talked about what happens if there is a massive loss, but only then will we know whether the products behave as they are expected to behave. It will be interesting to see how the markets react after a very large event but by and large, the value position will remain the same and you may just have different faces and market participants.
Steve: Is there anything you see as key to stimulating or assisting the ILS sector evolution?
Liz: It is very important that investors have confidence in the service providers who are managing the structures, whatever structure or vehicle it may be. If we continue to work towards building that relationship it will assist and enhance the market.
Philippe: I would like to see the gains we got on disclosures and improve corporate governance despite the market becoming softened. If we are going to extend to non-peak risks, then we will need to have some robust discussions around the models that are used and the quality of the data that comes in to see how it is taken into account.
Dirk: As you move away from peak peril well modelled risk to less understood risk in using indemnity triggers, we need to ensure that the governance and protections that have been put in place for investors remain in place so that we don’t get exposed to moral hazard.
Philippe: I would also like to see that whatever else gets brought forward is not something that is taken from the traditional reinsurance market. I’d like to see the size of the pie grow rather than just the having the size remain the same with more going to ILS because they are cheaper. This would be a race to the bottom.
Chris: The current market conditions are extremely good at the moment so hopefully this will encourage new sponsors to sit up and take notice of the opportunities in the capital markets. From the retro market’s perspective, it is extremely compelling to access the ILS market so we should see plenty of sponsors coming to market this year.