One of the great unknowns of the insurance-linked securities sector is beginning to emerge: how low will investors go when it comes to pricing? Bermuda:Re+ILS explores industry sentiment that a floor of sorts has now been reached.
Despite the growing maturity of the insurance-linked securities (ILS) sector, the market has been able speculate about only certain elements of it, so far. How investors will react to a large catastrophe loss is one of the more popular subjects of speculation.
Another has been around how low investors will move on prices of cat bonds. Yields have declined steadily in recent years, mirroring rates in the traditional sector. It was never exactly a game of chicken but some traditional reinsurers will certainly be relieved that it now seems the limit of some investors has been reached.
The dynamic around this is an interesting one more generally for the risk transfer sector. The main reasons investors buy ILS are twofold: it offers diversification from almost any other investment product they hold, and the yields in the sector have been much better, in proportion to the risk, than most other types of investment in recent years.
While the first dynamic will not change, the second could—and this should be a concern for those betting on a thriving ILS sector.
The poor returns elsewhere have, in part, been a product of the extended low interest rate environment that has now been in place for well over five years in most developed markets. This has had a devastating effect on bond yields and investors have sought better returns wherever they can find them—ILS has been one of these places.
But what goes down must also go up again. If ILS returns are not quite so favourable, either some investors would reduce their allocations to ILS or the cost of coverage using this risk transfer technique would increase.
Rates are plateauing
Back in the reality of the present low interest rate environment, however, there is great evidence that rates are starting to flatten out. Martin Bisping, global head of non-life risk transformation at Swiss Re, pointed out in a roundtable in Monte Carlo held by sister publication Intelligent Insurer that the market is over-capitalised at the moment—and the capital is still flowing in.
As a result there is price compression in many areas, he said, not just in the traditional reinsurance market but also in the alternative capital space, and cat bond spreads have declined. He added that the cat bond market is showing some discipline.
Urs Ramseier, chairman, Twelve Capital, said that in order to understand the dynamics it was important to understand the motivation of the investors in providing capital to market. The majority are pension funds that invest for diversification reasons, with others having slightly different types of reasons, such as high-net-worth individuals investing for capital gains tax reasons.
He added that on the private ILS side there were signs of a slowdown, with investors asking whether it was a good idea to invest at current levels. Some investors might now take some chips off the table, he suggested.
“Prices have dropped and investors seem to have funds ready on the sideline but are holding back because prices are not as good as they were." Henning Ludolphs
Others, all at the sharp end of investor sentiment in this space, agree. Darren Redhead, chief executive officer at Kinesis Capital Management, part of the Lancashire Group, believes there is downward pressure on rates.
Henning Ludolphs, managing director, retrocessions and the capital markets at Hannover Re, believes that growth in ILS market has slowed in recent months, partly because returns have dropped to the point that some investors are holding back from investing in the space.
“Prices have dropped and investors seem to have funds ready on the sideline but are holding back because prices are not as good as they were,” Ludolphs says. “Transactions are still profitable but less so than in the past.”
Guy Carpenter believes prices are stabilising, in part on the back of the continuing influx of capital, including via ILS, into the reinsurance sector; senior executives believe pricing could reach a level that would be appropriate for all parties.
“We believe current price levels for ILS could be a ‘golden compromise’ in which protection buyers perceive good value for fixed-price multi-year cover and investors continue to broaden and diversify their portfolio of holdings,” says David Priebe, vice chairman of Guy Carpenter.
“With the cost of issuing falling and time-to-market shortening, this equilibrium could provide a substantial boost to the market that the record issuance of early 2015 portends.”
This sentiment also applies to the traditional sector. Alex Moczarski, president and chief executive of the broker, says that average decreases have been mitigated ‘somewhat’ by more moderate decreases in US catastrophe reinsurance, especially wind peril.
“Reinsurers were more successful in resisting demands for large price reductions following two years of steep declines, while demand actually increased in some lines as clients continued to seek access to innovative new products and improved terms and conditions,” he says.
Manfred Seitz, managing director of international reinsurance at Berkshire Hathaway, says he believes that although a floor has not yet been reached on pricing, some of the bigger players are starting to draw a line in the sand.
“Some of the more important market players are starting to get cautious with the downside on price,” he says. “I have started to see placements done on price alone with the bigger players not participating.”
That pressure on rates applies to many lines and is not coming directly from alternative capital providers but from other reinsurers forced to diversify into new lines of business because they have been squeezed out of their traditional niche in cat business.
“They are diversifying into non-cat classes and rates are deteriorating as a result,” Seitz says.
The good news for everyone is that there is also evidence that the flow of capital into the sector is slowing. David Flandro, global head of analytics, JLT Re, believes that the rate of inflow of capital, whether from alternative, traditional, third party or convergent sources, is decelerating.
“Don’t get me wrong, it’s still coming in, but the rate that it’s coming in seems to have slowed,” he says. “Catastrophe bonds outstanding in the first half of the year have increased year on year, but this year, issuance seems to have decreased slightly and in fact some of the earlier estimates that were out there six months ago have been moderated somewhat. So, the rate of entry of third party capital seems to be moderating a little.”
Whether rates have reached a plateau or not, it has certainly done nothing to persuade the industry that the importance of alternative capital to the industry will diminish. In fact, more and more players seem to see access to this capital as increasingly important to their business models.
Getting in on the act
A number of firms have strengthened their commitment to this space in recent months—all seem certain that, whatever pricing is finally deemed appropriate, this form of risk transfer is here to stay and they need to be in on the act.
One was Kiskadee Investment Managers, the third party reinsurance capital and ILS unit owned by Hiscox, which launched a new platform that will allow sidecars and other vehicles to be easily formed using segregated cells.
Bermuda-based Cardinal Re has been described as a market-ready platform able to quickly create sidecars and managed accounts in a segregated cell. It will be run by Kiskadee Investment Managers, which also revealed it has hit the mark of assets under management of more than $600 million.
Jeremy Pinchin, CEO of Hiscox Re, has also revealed that further moves into the ILS space are in the offing. “We are currently looking for other alternative vehicles for our investors,” he says. “These investors are private wealth funds but not hedge funds.”
In a nod to the wider strategy, Pinchin says: “I saw the implications from the arrival of third party capital into the market and I also knew that I needed to diversify the business and tap into the new forms of capital coming in.”
Meanwhile, Tokio Millennium Re (TMR) has launched Capital Solutions, a new capital markets unit, designed to enhance the company’s reach into the capital markets. The unit will focus on developing new capital markets products and leveraging the use of technology to transact business with TMR’s capital markets partners.
Stephan Ruoff, the chief executive of TMR, said: “Capital Solutions draws together a number of disciplines such as IT, analytics, traditional reinsurance and ILS to work holistically with our risk position and with investors.
“It will bring the whole management system together. It means TMR will be able to offer greater capacity to its cedants, and it will help TMR manage its overall portfolio as well as better engage with capital markets partners on a number of fronts.”
Such new ventures underline that any notion that a floor may have been reached on ILS pricing makes little difference to the market sentiment towards this form of risk transfer. Perhaps, like any part of the industry, capital and pricing may ebb and flow but the structure is here to stay.
Private ILS market grows
While the growth of public and, thus, tradable ILS has grabbed the headlines in the recent months, another, slightly more opaque market has been growing in the background—bringing new participants into the space in the process.
Driven by lower costs and faster time-scales, the market for private catastrophe bonds has also been growing quickly, allowing counterparties not previously active in the ILS space to use this method of risk transfer, says John Butler, managing partner at Twelve Capital.
“The ILS markets continue to open up to private cat bonds, and that’s an area where Twelve Capital has been particularly active, with the firm investing in three such bonds in the second quarter of this year alone,” Butler says.
“From our perspective, we’ve found that more traditional counterparties who wouldn’t have previously been active in the ILS space have become interested in transacting in private cat bonds and, because we have a cost-effective platform, bonds can be effectively structured on behalf of our end investors.
“It takes about 10 days to put one of these together and the benefit of this is that we can introduce investors to more diverse risk through new counterparties who wouldn’t ordinarily have had the chance to issue cat bonds on the public markets.”
Butler says the rise of these bespoke deals has in part been driven by a growing sophistication among investors and due diligence processes that have continued to become ever more detailed over the past 12 months.
“Pension funds are well educated as to the nature of these risks, having historically always been the major providers of equity investment for traditional reinsurers,” he says. “Today, they just become more proximate to the same risk as their level of sophistication improves.
“Coupled with the significantly improved levels of detail and granularity around reporting, investors are being regularly educated by their manager around how investments are performing and frequently seek ever more innovative solutions in order to enhance returns.”
The growth of the sector will be boosted by increased volatility in the wider financial markets, Butler predicts. He explains that, by adding ILS to a wider portfolio, institutional investors will be able to reduce the volatility of their overall investments.
“With volatility expected to increase in the next two to three years, it is understandable that ILS will continue to have an ever-growing place within the context of a broader and more diversified portfolio,” he says.
ILS, David Priebe, Alex Moczarski, Guy Carpenter, Manfred Seitz, Berkshire Hathaway, Henning Ludolphs, Hannover Re, Bermuda