How to grow the pie


How to grow the pie

Monkey Business

As money continues to pour into re/insurance-linked and ILS funds, for all the bullishness from investors, the market must diversify if it is to continue to grow and be sustainable in the long term. Bermuda:Re+ILS investigates.

The reinsurance funds sector remains one of the fastest growing areas of risk transfer with growth of collateralised structures outstripping insurance-linked securities (ILS) so far in 2016 and a mixture of new funds and new concepts for risk transfer very much on the drawing board.

The idea of funds diversifying away from pure property-catastrophe risks seems high on the agenda of many investors, although for some the practicalities of how this would work remain unclear. That said, a number of initiatives look set to launch next year—in Bermuda and further afield—that aim to make this ideal of diversification a reality.

Lixin Zeng, the head of AlphaCat Managers, Validus Group’s fund management business, suggests this is already happening in some sectors, including in pure ILS deals, but does not believe such initiatives will gain traction as quickly as they have in the more traditional property-cat markets.

“We’re already seeing ILS transactions outside the core catastrophe reinsurance area such as specialty reinsurance—aviation and things like that—but I don’t believe that ILS capital can gain scale in those specialty areas,” he says.

“The reason they did in the property-cat area is because they are clearly a lower cost of capital when it comes to the peak catastrophe exposure. Such an advantage does not really exist outside peak zone catastrophe reinsurance, hence its potential is limited for ILS capital.”

Growth all round

The quest for diversification is taking place against a backdrop of more general growth for the industry’s most established funds. Funds managed by Leadenhall Capital Partners, for example, enjoyed steady growth in 2016. It is now managing more than $3.1 billion of assets, partly thanks to the contribution of its new catastrophe bond-focused Leadenhall UCITS ILS Fund (UCITS are Undertakings for Collective Investment in Transferable Securities, EU mutual funds) which it launched at the end of 2015, but also thanks to the growth of its other life and non-life funds.

“The question is simply which industry player has the appetite or agenda to take that first step.” Quentin Moore, Vario Global Capital.

Luca Albertini, chief executive, Leadenhall Capital Partners, says the total assets Leadenhall, which is an independently managed joint venture with re/insurance firm MS Amlin, is now managing have reached $3.18 billion, a big increase on the $2.41 billion it started the year with. “That is despite the fact we have one billion in sterling, which has depreciated by 10 percent,” Albertini says.

The portfolio is split roughly 50:50 between life and non-life products and part of the growth has been thanks to the success of the new UCITS ILS Fund, despite its not being overtly marketed.

This fund is now approaching $160 million, almost double its size when launched. It has grown on the back of reverse inquiries, he says, explaining that some investors are attracted by the idea of first entering this asset class by investing in a more liquid and transparent product while many funds have a certain allocation of assets that can be invested only in UCITS funds.

Albertini believes the ILS product should be limited to skilled institutional investors or via skilled advisors—so the distribution of this fund is tightly managed.

Leadenhall also has a number of open-ended ILS funds, including the non-life focused Leadenhall Value Insurance Linked Investments Fund, the non-life and life Leadenhall Diversified Insurance Linked Investments Fund and the pure life ILS investment fund Leadenhall Life Insurance Linked Investments Fund.

But, like Zeng, Albertini says that despite the current growth his funds are enjoying, the market will need to diversify and eventually find new risks.

“We need the total size of the pie to grow,” he says. “We need to do everything we can to grow new markets and push through ILS legislation in markets such as London, which would help. It is difficult to come up with new options when the market is so soft but new companies will come to the market when the time is right.”

He stresses that the demand side of the business remains very bullish. Investors are drawn by the uncorrelated nature of the risks and the healthy returns in comparison to other investors in this environment.

He believes that even if the wider investment picture were to improve, these investors will now not abandon the market. “It was the wider investment environment that pushed them to make an investment. But now they have done the hard work, they will stay,” Albertini says.

New launches

Leadenhall is not alone in seeing this strong and sustained interest from investors, while also seeking diversification. Industry veteran Dirk Lohmann, the CEO and one of the founders of Secquaero, the fund manager now 50.1 percent owned by the Schroder Group, plans to form a new fund dedicated to life ILS in 2017.

Lohmann believes demand for such a product is strong among investors and the fund could reach Ä2 billion ($2.2 billion) in size. “This is an ideal asset for pension funds seeking longer duration investments,” he says.

“They are faced with the problem of trying to match their assets and liabilities and they want long duration paper. It is also not correlated with cat business and the chance of losing all the principal is very remote. It is a natural fit for pension money but it could suit other types of investors as well.”

Lohmann acknowledges that the supply into the life ILS market is uneven and explains that the fund would seek commitments from investors that would be drawn down only as and when supply was available.

But he expects more deals to emerge in this space and notes that some very big life financing transactions have happened in recent years, leading him to believe that supply will increase.

This new fund will complement several the other funds managed by Secquaero including a European fund that invests in short tail risk including collateralised reinsurance and ILS but excluding life; its original pure ILS fund that comprises 20 percent life deals; a new US fund launched in December last year that mirrors is global ILS fund; and a cat bond fund it manages for Schroders.

Secquaero also has the mandate to invest in a mixture of collateralised reinsurance and other types of cat risk for a Swiss pension fund, launched late in 2015.

“Its launch will be helped by changes made by the Swiss regulator that allow companies to invest in ILS as part of their regulated investment portfolios,” says Lohmann.
A different ballpark.

Beyond the perhaps natural diversification into new asset classes other initiatives are afoot that could revolutionise the risk transfer industry and the capital markets’ interaction with it in much more fundamental ways.

Vario Global Capital, a venture unveiled in 2015, for example, has been working on developing a ‘whole portfolio’ ILS product as a capital management tool for insurers. It intends to open its first fund to investors in 2017.

Quentin Moore, founding executive partner of Vario Global Capital, says the venture has been working closely with potential clients in the past 12 months looking to structure private placements using the concept. Now, he feels confident that the first fund offering investors the ability to invest in these deals will be opened next year.

“It has been a very busy 12 months as we have been furiously paddling below the water,” Moore says. “The objective now is to get a fund to market next year. In what remains an uncertain economic climate it is tough to predict exact timescales but the hard work should be done behind the scenes by the end of 2016 and we always wanted to launch the first fund in 2017.”

The ‘whole portfolio’ ILS concept works by offering non-life insurers the opportunity to buy high level protection effectively on a quota share basis covering their whole portfolio using structures very similar to the typically catastrophe-based ILS deals.

The key function of such deals—which will, almost always, be by private placements into the capital markets—is capital relief for insurers under Solvency II or equivalent regulatory regimes in other countries. This will deliver greater capital efficiency and improved returns on equity.

The biggest inhibitor to such a solution has always been the difficulty of establishing a suitable mechanism for a bond being triggered and funds being released, especially in relation to long-tail liabilities.

Vario claims to have developed solutions to this problem using actuarial methodology—a portfolio modelling technology capable of setting triggers based on the performance of an insurer’s whole portfolio, taking into account factors including validated internal capital models and loss ratios.

Moore stresses that the ‘whole portfolio’ ILS concept, tipped last year to become six times bigger than cat bonds in the long term, has the potential to thrive and interest is picking up pace faster than expected.

“Post the Brexit vote, the investment side remains negative in most areas so this becomes increasingly appealing to insurers. Their margins are being squeezed all the time and we don’t see this dynamic changing. They are looking to cut cost and the next biggest cost after claims is the cost of capital.

“That was not a question the boards of many companies had previously been inclined to consider, but Solvency II and the way the rating agencies have changed their methodology has changed that. The question is simply which industry player has the appetite or agenda to take that first step. There are plenty of companies willing to follow but we are talking about a fundamental cultural shift here,” Moore says.

For the likes of Lohmann, faced with great demand from investors but a lack of supply, the idea of a new asset class is appealing. He says he would be very interested in speaking with Vario about the idea of ‘whole portfolio’ ILS and investing in deals structured by Vario.

“We would be open to investing in those types of structures and we would not need a third party to model the risk, we could do that ourselves,” he said. “Vario will need to educate the sponsors of these but we would be happy to invest.”

Is it time to regulate the funds industry?

The way funds market themselves and report their performance to investors has come under growing scrutiny in recent months, with a number of market participants highlighting the great discrepancies in the way this is done by different funds.

Darren Redhead, chief executive of Kinesis Capital Management, believes inconsistencies in the way reinsurance funds are reporting their estimated performance to investors and even selling themselves to new potential capital are becoming increasingly problematic for the industry and should be standardised.

“Kinesis, a fund offering collateralised reinsurance which was formed and capitalised by Lancashire Holdings in 2013, has always been transparent and realistic in what it tells investors,” Redhead says.

“It reports its long-term expected returns after losses and fees, for instance, which take into account average levels of loss activity during any pre-determined timeframe, and also after the impact of any potential trapped funds and delays of repayment which is really unique in the market.”

But, he claims, some funds do things differently, which can confuse and mislead investors. Others are opaque in terms of what they invest in.

“I am not saying there is a right or wrong way but there are inconsistencies and that can become a problem for investors,” he says. “There is no standard way of doing it. Some funds report their return without taking expected losses into account. We list every deal we do, including the pricing and expected loss, so we are fully transparent to our investors.”

He notes that an average return for many funds and companies in recent years would easily move into losses if catastrophe losses were to hit normal levels.

Redhead also believes that many funds do not reveal the extent to which investors’ capital is leveraged. While this can enhance returns, it can also cause problems in the event of multiple losses—something that should not be a surprise to investors or customers.

Lohmann agrees that there is room in the industry for standardisation but does not think a third party company such as a rating agency should play this role.
“Rating agencies do some good things but bringing their approach to funds would be too much,” he says.

These concerns around the way funds report their performance come against a healthy backdrop for the collateralised reinsurance sector, however.

“As many buyers have reached the limit of how much collateralised coverage they want on their programmes, the capital is finding a route into the industry in other ways,” Redhead says.

“We used to think there was a ceiling on how much capacity customers would want but the industry is increasingly putting this money to work in other ways.

“The old-fashioned term for it is fronting, but more reinsurers are effectively using their own paper with this capital in the background.”

Reinsurance, Validus, ILS, Bermuda, AphaCat,

Bermuda Re