ILS: the beauty of diversity
Momentum built in 2011 in the insurance-linked securities (ILS)/convergence market and Bermuda was at the centre of the action. ILS/convergence was the hot topic at the Ernst & Young Ltd. P&C Insurance Outlook 2011 conference, held at the Fairmont Hamilton Princess hotel on December 8. Speaking on a panel focused on ILS and the convergence of the capital markets and the insurance industry were Greg Hagood, managing principal and co-founder of Nephila, a company which manages some $5 billion of insurance-related investments; Beat Holliger, head of Munich Re Capital Markets, a major player in the catastrophe bond market; and Don Kramer, a Bermuda reinsurance veteran who has set up several companies on the Island and in 2011 established ILS Capital Management Limited, an asset manager focused on ILS opportunities. The discussion was moderated by Ernst & Young Ltd. former partner and Bermuda insurance sector leader Jonathan Reiss.
Jonathan Reiss: When we talk about the ILS/convergence market, what kind of structures are we looking at? And what are we not talking about when we refer to ILS?
Greg Hagood: I guess when most people think about ILS, immediately their brain moves to the catastrophe bond market. The cat bond market has been around for 10 to 15 years. It’s basically the packaging of catastrophe risk in a bond form. There’s no question that this is a meaningful part of the market and it’s here to stay. More recently, since hurricanes Katrina, Rita and Wilma in 2005, many other types of structures have evolved. The sidecar market really didn’t exist pre-Katrina, now it’s very much part of the fabric of the reinsurance market. It makes perfect sense: capital comes in when there’s a problem, stays around for a year or two, and capital goes away when the problem abates.
It’s very different from the 1980s and 1990s: when there was an event, new companies would form and the capital would be permanent. ILS is a very positive and healthy component of the market and, I think, for most reinsurers it will form part of their capital management strategy going forward.
Then you see some fund managers like us who do collateralised reinsurance. As opposed to being a cat bond, it’s just a direct reinsurance transaction in which collateral is posted. That’s considered ILS in today’s market. Then there are quota shares, which involve insurers looking for partners for their capital management strategy.
There’s a lot of fund managers out there today in this market. The number is growing as we speak. I think the interesting thing is that all these forms co-exist. There are certain players who participate just in the cat bond market. Some people are just in the ILW (insurance loss warranty) market and some in the retrocessional market.
In terms of what ILS is not, we get questions from investors about the Greenlight Re model, or the Third Point model, and is that ILS? To us, it’s a bit of a hybrid, focused on the catastrophe market and more focused on the asset side. So to us that is not capital coming specifically to the catastrophe market, which is all we do.
Reiss: In the past when we’ve seen imbalances between supply and demand, here in Bermuda we have seen waves of new activity. The growth has not been steady. We’ve seen the classes of 1993, 2001 and 2005, and there will be imbalances again. So what role will ILS play in meeting these shortages?
Don Kramer: The first major wave was in 1993 at a time when Lloyd’s dominated the catastrophe market. Lloyd’s pooh-poohed the Bermuda market and said after the first major hurricane, “you guys will close”. Instead, the Class of 93 created the environment that led to Bermuda becoming the leader in the catastrophe market. They all did reasonably well and at the end of the first year, they went public at 120 percent of book value.To the private-equity guys, this was a home run, it looked like easy money. The difference today is that companies trade at a discount to book value and they trade on book value rather than earnings, so it’s not as attractive to form a new company. So you can get 15 or 20 percent return on equity, if you’re lucky enough to get it, and find that your stock’s trading at 80 or 90 percent of book value.
"The lack of exit opportunities has changed the market environment. ILS capacity can enter and then be withdrawn, so it has ease of exit as well as entry and that is a major change."
The lack of exit opportunities has changed the market environment. ILS capacity can enter and then be withdrawn, so it has ease of exit as well as entry and that is a major change. The other considerations are valuations and the rating agencies. If you recall, on January 19, 1994 we had the Northridge earthquake and exactly a year later we had the Kobe earthquake. Companies took a fairly large loss initially and, had the rating agencies been around, they might have put these companies on negative ratings watch and downgraded them before they even had chance to rebuild their capital. So they have played an important role in reducing the leverage the industry has.
Meanwhile, ILS creates yields that in today’s environment are elsewhere unobtainable. Remember we’re at an interest rate at which Treasuries are trading at less than 100 basis points, where foreign securities are under tremendous stress and we’re worried about trade credit. So in this environment, coming up with a high-yield, noncorrelated product seems very attractive.
Reiss: We’ve seen in 2011 that the level of interest in ILS/ convergence has really bubbled up. Beat, you’re in the thick of this market. Do you think this uptick will continue?
Beat Holliger: It absolutely will. ILS allows the diversification of insurance risk and financial risk. If you look back to 2008 and the financial crisis, cat bonds were trading at 90 or 95 cents on the dollar, while many other asset classes were trading at 50 or 55 cents on the dollar. That really shows the value of these assets. People we meet with are really interested in diversifying their risks into other assets. We’ve seen a very active fourth quarter and we think the first quarter of 2012 will be very busy as well. I think the main driver has been diversification.
Hagood: Whether ILS is in the form of cat bonds or collateralised reinsurance, investors around the world are more accepting of this asset class. That’s partly because of the interest rate environment. When we first started dealing with this asset class in the late 1990s, people were looking for 15 to 20 percent returns. In today’s world, when we’ve had very difficult capital markets for the last 10 years, with interest rates at all-time lows, a 6 or 8 percent return looks out of the ordinary. So when you take into account the non-correlation, it’s not quite a no-brainer, but not far from it.
My personal opinion is that the market will continue to grow. The pool of capital in the capital markets is just so much bigger than the insurance market and able to digest those bits of volatility that people don’t want unless they’re compensated for it. In a bigger pool of capital that volatility is simply more digestible than in a smaller pool of reinsurance capital. It’s plain math. So our thesis is that over time, as more and more interest comes from investors, then the cost of capital should go down. The cost of capital over here is lower than the cost of capital on the reinsurance side. So that will be an interesting trend to watch over the next 10 or 20 years. Whether it’s in cat bond form, or some other form, risk is going to continue to trade.
The reinsurance market is not solving the world’s problems right now. If you look at Florida, North Carolina, Massachusetts—all these states have a lot of risk on their balance sheets but these needs are not being met by the reinsurance market. We have to consider the reason. This should lead to future growth.
Holliger: People now feel more comfortable investing in ILS. They expect to lose money after an event such as the Tohoku earthquake, but they expect to earn it back over time. So they’re putting more money into these asset classes.They are seeing superior performance over traditional financial market asset classes.
Kramer: Really, the biggest issue is non-correlation. The hedge fund industry got its tremendous growth from equity managers looking for 20 or 25 percent yields and doing private-equity deals. In the financial crisis, that all changed. They’re operating in an economy which is weak in Europe and the US. If you get into this non-correlated class, you have a chance of an alternative asset.
"The cost of capital over here is lower than the cost of capital on the reinsurance side. so that will be an interesting trend to watch over the next 10 or 20 years."
We met with a group the other day which manages about $4 trillion. They have almost $100 billion in alternative assets. That means they’re in hedge funds and other things, looking for high yield. If you look at the pension fund industry, they are dealing with low interest rates, and have to reduce the forecast for interest rates in future. The potential underfunded loss is staggering.So if you can find high yields from somewhere, then it helps out dramatically. Professional investment managers love to say “our benchmark yield is 2.5 percent and we achieved 2.65 percent”. When you get that alternative asset class that just gives you that little edge, it helps the manager to keep an account. So the potential demand is really staggering.
Reiss: How has the investor profile changed and what impact have the changes had on market pricing?
Holliger: We find that more and more investors are not building up the expertise themselves, but they’re giving their money to specialised funds. Their market share of ILS has increased from 25 percent to about 60 percent. It takes very specialised knowledge to analyse risk, so people tend to outsource that. Will that change? Well, if the market really explodes, then more and more asset managers will start to build their own expertise, but that takes time and it takes experience. You need to understand the models and the risks. Munich Re has been in this business for a while, but would we have expected an event like the Tohoku earthquake? No, probably not, because it was outside of the modelled area. That is just an example of how challenging it is to understand insurance risk.
Hagood: We started doing this in 1998, when the cat bond business was very much in its infancy. Very few fund managers or hedge funds were in this sector at all. It was pretty much like that until Hurricane Katrina in 2005. Post-Katrina, the market changed dramatically. You had hedge funds stepping into the market. Some of them were active in buying catastrophe bonds, some of them set up reinsurance companies in Bermuda, such as D.E. Shaw and Citadel, big hedge funds with $20 billion of assets under management, who were putting $1 billion into catastrophe reinsurance.
Fast forward to 2009, almost all of those hedge funds have now left, because they had broader problems with the financial crisis. Most of the hedge funds we’ll see will be opportunistic. They’ll come in when there is dislocation, they’ll stay for a few years and then they’ll step out—that’s what multi-strategy hedge funds do. A handful may set up permanent operations and do dedicated things like D.E. Shaw still does.
Something we’ve seen, particularly since 2008, was that as the hedge funds left, the pension funds came in. Pension funds found that everything was more correlated than the models suggested. When funding future liabilities, and when everything’s correlated, it makes your assumptions far less robust. So our investor base has dramatically shifted towards pension funds over the past three or four years. I also find it very interesting that some of the consulting firms have come on board with the asset class. After the credit crisis, they were looking around—what wasn’t correlated and what performed? There were not a lot of places to look, but ILS was one of them. So I think that while opportunistic hedge funds will come in and come out, the strategic non-correlation presented to pension funds will mean they will be investors in ILS for years to come.
Kramer: It’s about applying portfolio analytics to risks and building a portfolio that balances risks from all different sectors. You have, for example, Japanese earthquake, California earthquake, Florida wind and then you try to create a portfolio that is carefully constructed using investment metrics, applying a Sharpe ratio or a risk assessment return. You may look at something that has a 15 percent prospective return and turn it down for something that has an 8 percent prospective return, because you’re using portfolio analytics. You will inevitably get hit, but by diversifying your risks, you’ll create with greater certainty a protected yield.
Reiss: What do you think about Bermuda as a jurisdiction, and what does it have control over and what does it not?
Kramer: The insurance regulator, the Bermuda Monetary Authority (BMA), has come a long way and the government has signed more than 30 tax treaties. While we still have some version of the Neal Bill hanging around in the US Congress, it does not look as though it has much traction. We have talent and capital and relationships here, but on the other hand, what we have to recognise is that there is outsourcing, because there are a lot of functions that don’t have to be done here. The government is pushing the message that Bermuda is “open for business”, but business is not coming easily. But I think that as long as the talent is here, the insurance market will be here.
Hagood: We came to Bermuda in 1998, because it’s the centre of the catastrophe market. It seemed to make sense to us at the time. Since then we’ve seen the formation of the classes of 2001 and 2005. In the 13 years we’ve been here, the growth of the market has been extremely strong. The BMA has been phenomenally good for us. When we have needed to set up a new fund to meet a need, they have been great in that regard. It’s a solid and robust jurisdiction. From a fund manager’s standpoint, since day one it’s been a positive experience for us.
Holliger: We have no operation on the Island, but we do a lot of business here. Bermuda is a place with an established market and is both transparent and reliable. It’s been around a long time. That’s why we feel Bermuda should be considered over other offshore jurisdictions that offer similar capabilities.
Reiss: What’s your outlook for 2012?
Hagood: We’re going to continue to focus on what we do: that is, catastrophe business with a US focus. There is a lot of risk in the world that is sitting with governments and a) it should not be; and b) it’s not getting transferred to the private reinsurance markets or the capital markets. The state of Florida carries about 30 percent of homeowners’ risk in that state. Why should that be when the Florida economy is shrinking dramatically? It’s a similar situation in other US states, such as Texas, Mississippi and Massachusetts. We as an industry should be trying to find a solution. How do we do that? I don’t have the answer to that now.
Reiss: Governments have always been big carriers of catastrophe risk and they’ve never been in a worse position than now to deal with it. So that has the potential for phenomenal growth for the industry.
Holliger: We are committed to continuing using cat bonds in collaboration with traditional reinsurance.
Kramer: We are in the early stages of development and so we’re going to copy what Greg and Beat do! And we’ll use portfolio analytics.
