Bermuda Re examines the deployment and attractions of insurance linked securities and the need for differentiation in the face of the rising threat from collateralised reinsurance and alternative structures.
A number of Bermuda players are involved in the insurance linked securities (ILS) market, with ILS products presenting firms with an opportunity to diversify their portfolio—by both line and geography—and harness the potential of the capital markets. As Kathleen Faries, senior vice president – market solutions at Tokio Millennium Re made clear, the attraction of the ILS market is its ability to “complement the existing portfolio”. Faries said that such products would evidently need to “beat or exceed what we can achieve by writing traditional reinsurance treaty business”, adding that if the risk-return balance was favourable, the firm would consider such securities as additions to more traditional elements of the portfolio. She indicated that at Tokio Millennium, ILS investments are analysed the same way as their reinsurance portfolio, with the risks modelled and underwritten to ensure that the securities “stack up attractively”. And it is only when positive conditions coalesce that Tokio Millennium pursues ILS business, Faries said.
An unhappy correlation
However, conditions have been less ideal for ILS products in recent months, with pricing “tracking more closely to that of the reinsurance market”. As Faries outlined, initially the intention of ILS-type products had been to create a pool of investors that would provide sponsors with capacity that would provide diversification from the traditional reinsurance market. However, increasingly, ILS and traditional reinsurance pricing has coalesced. Rather than a clear demarcation between the two products, ILS has followed the reinsurance market in step, meaning that should a significant event occur, ILS capacity is likely to show similar market volatility to reinsurance capacity. Instead, buyers now have to contend with the potential volatility of correlated risk, with circumstances making a close examination of risk-return on ILS products all the more pressing.
"ILS products will need to become less complex and provide more transparency in order to de-couple from the traditional reinsurance market... there was a need to standardise, open up and simplify ILS in order to make them mroe accessible to investors."
Whilst ILS remain “uncorrelated to the financial markets”—acting as a diversifier for asset-based risk—Faries said that ILS products will need to become less complex and provide more transparency in order to decouple from the traditional reinsurance market. She said that “sponsors tend to view ILS products as just another reinsurance buy”, adding that there was a need to standardise, open up and simplify ILS in order to make them more accessible to investors that do not have analytical reinsurance expertise. Buyers may need to take on a bit more basis risk in order to get capacity that truly functions in a non-correlated way to the rest of their reinsurance programme. In so doing, such measures would help to de-link ILS from the traditional reinsurance market, encouraging involvement from investors other than the dedicated hedge funds and reinsurers that currently predominate.
Attractions nevertheless remain
Despite the close linkage of ILS and reinsurance pricing, Tokio Millennium has nevertheless become increasingly involved in the ILS cat bond space. Tokio Marine, the reinsurer’s parent company, was the first Japanese insurance company to sponsor a cat bond, and Tokio Millennium has since built up its presence and involvement in the ILS space as the firm has strengthened its Market Solutions division. As Faries outlined, the firm has “dedicated more time and manpower” to the sector, with Tokio Millennium viewing ILS as a valuable potential diversifier. Addressing Tokio Millennium’s approach to ILS purchases, Faries said that the firm generally takes a “buy and hold strategy”, but said that recently—due to tightening spreads and the effects of the RMS model change—the firm has been “looking more closely at secondary market trading”.
Addressing those ILS products that Tokio Millennium is involved in, Faries said that the firm “looks at any non-life new offering that doesn’t contain Japanese risk”. She added that if the bond complements the company’s existing portfolio and has a good return then it would be considered by Tokio Millennium’s team. However, “spreads have been tightening” on ILS bonds, down from those levels that sought to attract investors “back into the space after the financial crisis”. Not helping matters have been recent RMS model changes, which have placed further pressure on pricing and added a new level of volatility on valuations. Looking forward, Faries said she expects spreads to “track closely with the overall reinsurance market”, with a “slow upward trend” likely on the back of recent model changes and 2011 cat events.
Compare and contrast
Addressing the decision to opt for ILS products as opposed to more traditional reinsurance, Faries said that the value analysis and risk decisions behind opting for ILS are “very similar”. The key difference is that “because we are putting up the cash, we don’t just analyse the risk side, but must look at the return side relative to what kind of haircut we need to take for tying up that capital”. And with most bonds having a three-year duration, considerations must be made as to whether that money might be better deployed elsewhere. As Faries outlined, with cat bond funds typically invested in the treasury money markets, the question becomes whether other conservative asset classes or an alternative use of capital would constitute a better return on investment. There is the opportunity to access the secondary market should the value of bonds begin to decline—providing liquidity if need be—although Tokio Millennium for its part typically views ILS as “a tie-up for a particular amount of time and doesn’t do a lot of secondary trading”, Faries said.
Despite low spreads and ILS products’ relative correlation to the traditional reinsurance market, opportunities nevertheless remain. As Faries outlined, ILS bonds enable sponsors (reinsurance buyers) to access a “separate pot of capital”, which “for the most part does not have the same capital requirements or constraints of rated reinsurance companies”. The hope is to create a pool of capital that “will react differently” to the wider reinsurance industry and those events that occur in the cycle, helping to smooth out the impact of cat events, market dislocation or a turn. And after operating in the ILS space for a time, those “relationships already established” with the capital markets enable firms to draw down additional capacity should they be unable to place risk in the traditional reinsurance market.
"The overall cost of structuring and putting a cat bond into the market remains a significant impediment and is likely to prompt further conversations regarding the value of introducing simplified, off-the-shelf products."
Faries added that the challenge remains to “grow interest in securitising risk” through the ILS market, with recent efforts towards “cat bond light”—a means to “securitise risk more efficiently and at lower cost”—likely to raise interest in participation. Such moves will require a concerted effort from the ILS community and a push towards more off-the-shelf products, but it is evident that there is a will to attract further investors into the ILS space. Touching upon such efforts, Faries said that with 144a placements, there are Securities Exchange Commission (SEC) regulations that must be conformed to, which have served to impede simplification, but added that in response, there are “ongoing discussion regarding the need to move towards a more transparent, standardised market” in order to more fully differentiate capacity from that of traditional reinsurance. Instead, what we might see is a move to privatisation and alternative products.
Finally, addressing challenges in the ILS space, Faries said that the main issue is “finding enough risk to feed investor appetite”, with the supply side still proving “a challenge”. Meanwhile, the overall cost of structuring and putting a cat bond into the market remains a significant impediment and is likely to prompt further conversations regarding the value of introducing simplified, off-the-shelf products. At the same time, the industry is pursuing more private placement and the involvement of new participants, with Faries citing the participation of the Mexican government in Multicat as a case in point. By developing the involvement of such institutions, the ILS industry is looking to diversify its traditional pool of investors—typically ILS-dedicated hedge funds, reinsurers and institutional funds—and take the ILS offering to the next level.
BSX: proximity knocks
For those Bermuda players considering ILS, one needs look no further than the Bermuda Stock Exchange (BSX), which has become an increasingly significant market for international cat bonds. As BSX president and chief executive officer Greg Wojciechowski outlined, with Bermuda “already home to 1,400 insurance companies with total assets of $442 billion, it is the natural place for setting up insurance linked securities”. A host of Bermuda players are already involved in the issue of ILS products and sidecars, with the Island enjoying a depth of “historical interest and knowledge” in the space.
Since Island legislation was introduced back in 2009 to streamline the setting up of ILS products, the ILS market has grown steadily and the BSX now boasts nearly $2 billion of listed ILS structures, with the level of issuance indicative of the work of the BSX and the level of interest in the Bermuda ILS market. Addressing the BSX’s success, Wojciechowski said that the exchange’s goal “has been to ensure that Bermuda is in the front of mind for the creation, listing and potential secondary market trading of ILS”.
The BSX has been active in promoting the benefits of ILS, with public listing providing investors with an additional “layer of transparency”. This coupled with a “critical mass of insurers and reinsurers, the infrastructure to deal with them, and rigorous regulation from the Bermuda Monetary Authority and the BSX” serve to make ILS, and BSX as their home, the obvious choice for Bermuda players considering leveraging the capital markets.
Addressing expectations for ILS issuance in the second half of 2011, Wojciechowski said that the signs are positive. Paul Shultz, president of Aon Benfield Securities, said that “while primary issuance in the second quarter of 2011 was considerably lighter than in the same period in 2010, catastrophe bond issuance from repeat issuers remained strong”, with Aon Benfield Securities predicting that ILS issuance will be “strong as we move into the latter half of the year, and especially during the fourth quarter of 2011”. 2011 looks set to be another good year for the exchange.