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The organisers of a discussion about what makes investors commit to ILS chose a song by The Clash to make their point. It could just as easily have been Aretha Franklin’s anthem about respect to remind ILS managers not to take that commitment for granted.
Recent years have seen a rise in investor frustration with insurance-linked securities (ILS), including issues arising from loss creep and COVID-19. In a discussion titled “Should I stay or should I go now?” at ILS Bermuda’s Convergence conference, investment experts were asked: which issues are “manager-made” and which are systematic to the asset class?
The panellists were Eveline Takken-Somers, senior investment manager at PGGM; Miguel Da Ponte, senior vice president and head of investment management at Clarien Investments; Todor Todorov, vice president of business development & investor relations at Elementum Advisors; Craig Dandurand, an institutional investor and formerly the head of debt at Future Fund; and Philipp Kusche, global head of ILS & Capital Solutions at TigerRisk Partners. Their discussion was moderated by Jan-Hendrik Hein, head of investor relations & business development at Hiscox ILS.
“I’d prefer to have a better definition of the covered events as part of our investments.”
One day it’s fine and next it’s black
Takken-Somers highlighted the top three topics on her wish list: rate adequacy, a strategy for trapped capital, and narrower terms and conditions.
“It’s fair to say that ILS was designed for a Hurricane Ian event, but the problem is we were not paid during the prior five years because we have been paying out claims for minor US events. If that is representative of the next five years, then rates should come up tremendously and retention should also be increased because you need to have a buffer for a big event,” she said.
Although solutions to trapped capital have been sought in the last five years, these have mainly been to roll over capital from one year to the next which is normally efficient, she said. To exit an investment or reduce capital, however, entails “ending up in buffered situations”, where a lot of capital is trapped.
“Capital is a scarcity at the moment and so it should be valued more, and hence we should actually be paid for keeping our capital trapped. That would be something we urge our managers to take a look at,” Takken-Somers said.
On narrowing the terms and conditions, she said a cat event is, from a pension fund perspective, “something that we can explain internally”. Terrorism or business interruption because of COVID-19, however, are not things that a pension fund was expecting.
“I’d prefer to have a better definition of the covered events as part of our investments. Where we are today, the pension fund is at, or slightly above, target allocation and so, going forward, we expect to be more selective and take a harder look to see what we can improve to make it a more efficient product. What we will also do is reduce capital if the conditions start to deteriorate.”
Hein asked whether the reason her company was “slightly above” target allocation was market corrections to the remaining asset classes.
Takken-Somers replied: “No, that’s just the result of equity and fixed income markets having a rough period.
“All they have is an expense line that comes with adjusting the claim.”
It’s always tease, tease, tease
Dandurand said Takken-Somers’ comments were “spot on”.
“It feels a bit like being a parent whose kid has gone to the cookie jar and come away messy, and says to them: ‘I’m not mad, but I am disappointed’, because there’s been a lot of ‘learning after the fact’ about what contracts entailed, what the coverages were.”
The ILS sector is “above board, open and trustworthy”, he stressed, adding: “It’s not as if there’s been bad behaviour per se. It’s just been sloppiness that’s led to the disappointment.”
Part of that sloppiness is a function of an environment where there is more capital in the market than there is need for that capital.
“That’s not just confined to insurance, not by a longshot, but it leads to softening and weaknesses,” he said.
Adding to Takken-Somers’ list, Dandurand questioned the alignment between the end allocator’s capital and where that capital ultimately goes.
“Back in the old days, you had part of a tower that was retained by the primary insurer. Certainly by the time I started looking at these things that was very rare, except to the extent that maybe I’ll get the Florida Hurricane Catastrophe Fund in certain layers. And the problem with that is the primary insurer has absolutely no alignment and, in fact, probably has a disincentive to proceed with effective underwriting or claims management, because you get into a particular situation with a loss that is going to go above that and they have no skin in the game. All they have is an expense line that comes with adjusting the claim. So, in turn, all that sloppiness falls upon the backs of the reinsurer.”
He continued: “As the ILS community grew, and more and more of that reinsurance risk got ceded off to an investor, you actually take one more element. And then, the incentive for a reinsurer to actually go off and press the primary insurer diminishes to a degree as well. This isn’t venality but rather benign neglect and the end result is the significant amounts of money that the end investor puts up, in pursuit of providing genuine protection against catastrophic events, gets whittled away by misalignment. That’s when you wonder how much of the return over the last few years would have been whittled away by that and by surprises like COVID-19.”
Such a situation can lead to a lack of credibility, he said, not built by one major fraudulent event but rather by the “nicks and cuts that leaves somebody limping and asking, ‘Why do I think it’s going to be better this time?’”.
“There’s going to be a continued ‘flight to quality’ of managers and reinsurers.”
Exactly whom I’m supposed to be
Kusche said it all comes down to transparency and risk assessment.
“Transparency around quantifying risk is going to be key, which can be by extracting certain perils. When you look at the capital market, we have seen a very clear trend of more named perils and single-peril type structures, which are done in an attempt to make things more transparent and more clean.
“I think we’re seeing a similar trend in the collateralised area, where people shifted from all-perils coverage to more named-perils coverages. I think that’s all in an attempt to make discussions like this easier—to know, after an event, what’s covered or not, and to get a feeling for how big an event is and how it rolls into exposure. Inflation and other things are going to play into this. There’s significantly more time spent by the industry and managers to try to be more transparent, but I definitely agree with Craig that there have been many problems over the last five years, and people recognise where the hotspots are. What this will mean is there’s going to be a continued ‘flight to quality’ of managers and reinsurers, and others who understand these issues, trying to address them, versus those who take a different view.”
Todorov said that the hard market has been caused by the prior soft market.
“We got sloppy,” he said. “Terms and conditions were too broad and transparency with the definitions of contracts and what they were covering was lax. Now we are in a situation where it’s a hard market, and there is definitely some disruption and disbalance between supply and demand for capital.”
He agreed with Kusche’s point that there had been a return to “some of the good practices”, including structures around alignment across the tower.
“Hopefully, with this cycle, we’ve learned our lesson. We should be more disciplined as an industry and not fall for the same traps that we did five or six years ago, during the years with abundant capital.”
Takken-Somers said PGGM had 13 partners, and Hein asked her whether it had “pulled mandates with managers” on the back of some of these challenges. She replied, “Yes, with three, but for very different reasons connected with the philosophy of the company.”
With that, Hein then turned to the audience and said, “Managers and their peers: be warned, or the investors will vote with their wallets!”
“We want managers who are prepared to take a concerted allocation.”
If I go, there will be trouble
Hein then asked Da Ponte for the key characteristics he looked for in his most recent manager search.
Da Ponte said: “Broadly, we were looking for flexibility in portfolio construction—so, types of perils, regions, attachment points, various types of products that they use (industry loss warranties, traditional reinsurance, retro).”
Another requirement, he added, is the ability to commit to a different variety of investment products at different times.
“The traditional equity manager uses a LAVA chart and we would ask them what that had shown over the previous seven years for the types of perils that they’d done, because we want managers who are prepared to take a concerted allocation. The question of trapped collateral was big; not just how you are handling it now, with the funding arrangement or whatever, but how have you handled it in the past? Whether it was earthquake or wind, how much trapped collateral did you have? Because, from a return on invested capital perspective, we wanted to be able to say, how much extra I am going to have if you’re going to keep 10 percent trapped capital, and I can’t roll that 10 percent into next year but I want to maintain my same investor?”
Da Ponte said he has three “litmus test” questions: “Tell me your investment philosophy in less than two minutes (because you should be able to describe that and in layman’s terms to me); what do you believe is your edge over your competitors; and how do you believe you can maintain that edge going forward?”
“A bit of diversification in the portfolio is probably a good thing.”
This indecision’s bugging me
Hein asked the panellists for their responses to the question, “should they stay or should they go now”.
Quoting American writer Mark Twain, Da Ponte said, “History never repeats itself, but it does often rhyme.”
A former senior vice president for investments and pensions at BF&M Group, Da Ponte said: “Putting on my pensions board of governors’ hat, I’d say that allocating capital is all about opportunity cost. So if I put my money here, what am I giving up over there? Annualised returns over the past 15 years have been about 6 percent net of fees. I can take a two-year US Treasury bond right now and earn 4.25 percent, investment grade credit 5.7 percent and high yield 9.7 percent. Those are all asset classes that I as a board member totally understand. Its bond mathematics and two of those are going to give you historically more than ILS.”
He then referred to equity markets and the Wilshire 5000 Total Market Index.
“So, small caps all the way up to large caps in the US. After being 20 percent down, what are the returns for the next 12 months historically, on average? Twelve percent. Equities right now are down 25 percent. So I had the possibility to maybe make 12 percent. What I’m getting at is, you have the ILS industry that’s only giving you 6 percent, has tail risk, and losses can be really high. Why would I commit capital to something that’s only giving me 6 percent when bonds right now can give me 7 percent? That’s how board members on pension funds are thinking.”
If you don’t want me, set me free
Dandurand noted that, hypothetically, three investors with exactly the same opportunity could have “one that stays the course, one that doubles down and one that goes to zero” and they would each have logical reasons for doing so.
Such a scenario would not appeal to “marketers for an ILS shop”, but it underlines their obligation to articulate their value proposition.
“You have to be prepared to answer questions before they’re even asked because if I’m to-ing and fro-ing with my board on another line of capital, then it’s a tough sled.”
The ILS market has a lot of opportunities, he stressed, if they have the right structure and at the right price.
“Opportunity coincides with a broader financial market environment which is volatile and with low public equity valuations of reinsurance companies not attracting private equity, and a hugely increased demand by inflation. Also, we’re looking at $20 to $30 billion of shortfall before Hurricane Ian and then significantly larger after Ian. It’s unlikely that any capital inflows will even partially make up for some of the capacity needed, which ultimately will create opportunities for investors who understand the space and are willing to dive into it in more detail.”
Todorov stressed the “fundamental thesis” of ILS as an asset class still holds.
“This is an uncorrelated diversifying return stream and, if anything, the last 12 months in traditional financial markets have reminded us that a bit of diversification in the portfolio is probably a good thing. This asset class can offer that as a piece of a much bigger pie. Now is the time to address the issues we’ve seen over last six or seven years, and make sure that this asset class is resilient and stays resilient for the future.”
Takken-Somers concluded: “The 2023 opportunity definitely looks more attractive than we have seen over the last couple of years. So, with that, I think it’s fair to say we will likely stay for another year but we will be a. more selective and b. if rates start to deteriorate, then we will likely decrease as well. We believe that we’re not entering this per se hard market, but into a market where rates are adequate for the risks that we are taking, and so it should be going forward for us to become a sustainable part of it.”
ILS, PGGM, Future Fund, TigerRisk Partners, Clarien Investments, Elementum Advisors