An intricate game

In an ever-evolving market, fund managers are seeking out new strategies and structures to efficiently make the most of the insurance-linked securities (ILS) market.

The past 24 months has been peppered with ‘cat bond lite’ transactions which, due to their lower capital requirements and reduced level of document complexity, have opened the door to a new wave of private ILS cedants.

For Twelve Capital, a fund manager which focuses on multiple asset classes, these transactions have helped to generate positive returns for investors, while encouraging new, or rarely seen, perils into the ILS sector.

“The last 12 months have seen a major uptick in cat bond lites, driven by greater simplicity of the platform for the cedant and a growing motivation in terms of where the pricing and concentration of risk is in the private market on the part of fund managers,” says John Butler, managing partner and head of sourcing at Twelve Capital.

“We’ve chosen to issue bonds via our own platform, even though they’re being brokered by major intermediaries that most of the time have their own platform, because of the speed and level of internal expertise that we have. It takes us less than 10 days to bring a cat bond lite to market.”

Delivering a much smaller transaction than a public cat bond, Twelve Capital issues its Dodeka transactions at around $20 million, driven by the fact that the manager is producing these bonds for the benefit of its own funds.

This tailor-made approach has opened the door to new cedants.

“Our Dodeka transactions, which we’ve spent the last two years refining, are not seen as having challenging documentation, and are in fact very similar to a reinsurance transaction, hence making them much easier to issue,” says Butler

He also explains that historically, it was only those individuals directly involved in the cat bond world who were looking to innovate, but these ‘lite’ transactions have encouraged cedants who weren’t otherwise engaged in the ILS space to become involved.

“There is spread compression in the cat bond market overall and it’s still currently dominated by US South East wind. Cat bond lites give us an opportunity to develop risk for our pure cat bond investors which is better returning and/or exposed to regions which aren’t being well served in the current cat bond market,” he says.

Accurate analysis

For Twelve Capital, the use of private ILS and cat bonds allows it to leverage bespoke offerings for clients that might not otherwise be able to access such opportunities.

Its unique positioning as a mixed asset class manager also allows the company to use the catastrophe cycle to dip in and out of catastrophe bonds to generate the needed returns in an increasingly challenging market.

“Alongside our cat bonds and pure debt investors, we manage an increasing volume of capital within our ‘best ideas’ structure, which is where investors come to us and give us the flexibility to invest across our product lines through each cycle,” explains Butler.

“As US wind bonds generally earn the majority of their returns during the wind season, in managing a ‘best ideas’ fund, we can invest in wind bonds during the season—whether that’s investing in public bonds, or through our own private cat bonds that are exposed to wind perils, which we produce as six-month wind season-only deals.

“Then through the off season, we invest in publicly traded sub-debt insurance bonds. Investing between the two allows the money always to be on a positive earnings phase. It also allows flexibility of movement between two liquid markets, alleviating the concern over expiry dates and capital return.”

Twelve’s successful investment strategy stems from the capability to invest in and analyse both catastrophe risk and credit risk, which Butler says is simply a question of accurately analysing the market cycles and the counterparties that the company uses.

However, there is still a level of caution among some players around the cost and complexity.

“The major hesitation with regard to cat bonds is speed of execution for a transaction. The industry loss warranty (ILW) market might offer something tomorrow or at the end of the week, but a public cat bond might take three months to get the documentation and offering details together. The other issues centre around costs and documentation complexity,” says Butler

“For us, we don’t expect the cedants to bear the setup costs. All our cedants see is the standard trust documentation that they would have previously had as a collateralised reinsurance transaction. They don’t want to get further involved in the documentation because they don’t have the expertise in-house.

“The last set of Dodeka transactions have all been with traditional reinsurers, and they have been complimentary about the fact that they haven’t had to be involved in the setup process, beyond the normal interaction of a cedant with a collateralised reinsurer.”

Seeking growth

While the future of smaller, cat bond-only managers may be uncertain as market pressures grow, Twelve Capital has the back drop of its other asset classes to rely on—and the power to join the wider industry trend of acquisition.

“The fact that we’re not a sole ILS manager gives us a certain solidity and longevity. For cat bond-only managers, unless there is an increase in returns, I think these businesses are going to struggle,” explains Butler. “However, for us, if the right option came along, we would certainly consider being active as an acquirer. We’ve successfully acquired in the past, and we would do it again.”

Providing clients with access to the ILS market via collateralised treaty, private cat bonds and public cat bonds, Butler says, Twelve Capital offers a different set of economics from other fund managers.

“On the flip side, we offer senior and subordinated insurance debt transactions and we’re in the process of moving into the public and private insurance equity space as well. Given our unique offering, I think Twelve Capital will stand the test of time,” he says.