We discuss the development of the investment environment for insurance-linked securities with Kathleen Faries and Edwin Jordan at Tokio Millennium—with the two providing perspectives from an ILS market specialist.
What is being done to improve the commoditisation of the ILS product?
KATHLEEN FARIES: Given the complexity of insuring and securitising catastrophe risk, I am not sure we will ever get to a truly commoditised product. The existing investor base has become more educated and more comfortable with the nature and complexity of the risk, but the risk remains difficult to commoditise. We have seen long-term investors getting more comfortable with indemnity based cat bonds, but this is more to do with investors getting more sophisticated in their analysis and understanding the underlying risk than the market becoming commoditised. We still have some sponsors preferring indemnity cover which complicates the product.
We can, however, work on gaining transparency on the volume and price of secondary market trades. There are now more secondary trading brokers providing bids and asks, which does help, but there still isn’t the transparency that we have in other financial markets which makes our market more difficult to enter as a new investor.
EDWIN JORDAN: The natural buyer of catastrophe risk protection is an insurance or reinsurance company hedging its own risk. Because the spread between premium and expected loss is usually so large, there are not many others that want short catastrophe risk. Therefore to commoditise an ILS product, it is necessary for the reinsurance company to take basis risk. As long as indemnification products exist at a reasonable price, it will be the sellers of catastrophe risk protection that will have to adapt to triggers that are unique to the buyer.
How can investors compare ILS investments, and what is being done to strengthen such insight?
FARIES: Getting more transparency in the market on secondary trades and associated prices would provide necessary data in order to assess the overall value throughout the life of these bonds. If the market makers were to provide this information on their secondary trades it would be extremely helpful to the overall market.
JORDAN: Reinsurers such as Tokio Millennium Re have the ability compare ILS against similar risks in their existing traditional reinsurance portfolio. We also analyse the risk through our own proprietary and additional vendor models in order to take a view of the attractiveness of an ILS.
What are the key market considerations for ILS investors and how are these likely to develop?
FARIES: Critical to the market is the supply and demand for cat bonds. As more investors outside the reinsurance arena come into this alternative asset class we could see cat bonds become less correlated with the overall reinsurance market and more about the ability to access a different capital base. The considerable demand for the Everglades Re cat bond gave its sponsor, Citizens, leverage when placing their traditional reinsurance programme. Until, and unless, the two are understood to be completely different capital providers, there will be continued pressure on reinsurers.
Writing lower into a programme is a completely different proposition, which involves a different view of the risk. Pricing of cat bonds should not necessarily be following trends or cycles we see in the traditional reinsurance market. Capital markets investors could, and should, take their own view of the attractiveness and returns on the risk spread provided in a cat bond and this analysis should be independent of the pricing or terms that are being offered in the traditional reinsurance market.
JORDAN: As a bond investor moves down the credit quality spectrum, more scrutiny needs to be placed on the issuer. As a reinsurer, we are basically investing in junk bonds with high probabilities of default. We need to scrutinise the cedant’s exposure data quality, underwriting, claims handling, policy deductibles and growth plans. At the junk bond end of the spectrum, it is less about severity and more about frequency.
How has the buyer base of ILS deals developed? What further steps can be taken to broaden the appeal of ILS to institutional investors?
FARIES: The base of investors has been relatively the same for some time: dedicated ILS funds, institutions, hedge funds, reinsurers and mutual funds. What has varied over time is their level of participation. For capital markets and institutional investors, a factor contributing to the level of participation is the condition of the financial markets. For reinsurers, one factor is how the cat bond returns compare to the rest of their traditional reinsurance portfolio. Investors are always going to ask what kind of returns are available elsewhere. Pension funds are extremely interested in this asset class to diversify their portfolios with a non-correlating asset, but they need a larger market to really see this asset class as a long-term and viable part of their portfolios. Many pension funds are waiting on the sidelines until this market grows.
"We need this market to start to trade independently of the overall cyclical nature of the traditional reinsurance market in order to see real long-term growth."
JORDAN: Without an investor being able to analyse catastrophe risk beyond what is included in a prospectus, it is wise for them to stick to the very low probabilities of expected loss. The problem is most buyers of catastrophe risk protection don’t purchase high enough, so there is a lack of demand at the layers that make sense to utilise ILS.
How significant a component of the market is ILS trading? How do you expect this to develop?
FARIES: Investors looking for a liquid investment want these bonds to trade. The challenge that we have in this market is that it is stillrelatively small, with a small number of investors trading these bonds. In order to have real liquidity we will need more transparency and more investors. In order to satisfy increased investor interest, however, we need more sponsors and more cat bonds in the market. This year is proving to be a good year for new offerings, but the market is still very small in comparison to other investment markets. The total size of the cat bond market is in the range of $15 billion, with new issuance in 2012 currently at $4.3 billion, whereas the size of the US municipal bond market is on the order of $3 trillion, corporates $8 trillion and daily US bond market trading volume at $800 billion.
JORDAN: Reinsurers generally have a buy and hold strategy. We spend considerable resources analysing new issuances and usually take a one-year view, ignoring seasonality. However, I follow the secondary market since it gives an indication of catastrophe rate movement.
How can greater liquidity be injected into the market?
FARIES: We need to have access as investors to the actual prices at which cat bonds are traded. We need for these trades to be made public. Could they, for example, be listed on the Bermuda Stock Exchange (BSX) so that we could have a way to track what a bond is trading at, and the market value as a whole? If we could also then increase the supply side of this market we would attract investors that are currently not participating in this asset class. The supply side has proved a challenge over the life of cat bonds. With spreads contracting we may start to see this market continue to expand as we did this year. However, we need this market to start to trade independently of the overall cyclical nature of the traditional reinsurance market in order to see real long- term growth. The more this market can maintain its independence as a separate capital base, with the ability to provide significant capacity for extreme events—but with a view of the risk that is distinct from other sources of capacity—the closer we will get to a sizable and liquid market.
JORDAN: If the market were completely liquid, it would be easier for all of us to balance our portfolios. On the other hand, the lack of liquidity often creates opportunities for those of us in the business of writing long catastrophe risk.
Kathleen Faries is CEO of Tokio Solution Management. She can be contacted at: email@example.com
Edwin Jordan is chief underwriting officer and chief strategy officer at Tokio Millennium Re. He can be contacted at: firstname.lastname@example.org
ILS, Tokio Millennium Re, reinsurance, Tokio Solutions Management, cat bonds