A bumper crop -- cat bonds
What factors have made this year’s fi rst quarter insurancelinked securities (ILS) issuance so significant?
Jason Carne: The industry remains a relatively young one, but as it matures there is a certain level of confi dence that is instilled into the market. The cost of transactions is improving and while sponsors may argue that they would like to see the cost come down still further, the greater the volume of transactions and the more streamlined they are, the more attractive the pricing should become.
From an investor perspective, the insurance-linked securities (ILS) market is now seen as a more attractive investment prospect, not only from a diversifi cation perspective, but also from a standpoint of yield. Institutional investors view it as a position that is non-correlated to the capital markets with a risk-reward profi le that is very attractive.
During the first quarter we saw record levels of catastrophe bond activity which is expected to continue into the second quarter with the Everglades Re transaction, a $750 million transaction and the largest single issuance of a cat bond, which was a positive sign for the market. I feel optimistic about the future of the ILS market.
Why are Bermuda special purpose vehicles proving so popular for the creation of ILS vehicles?
Adam Smith: Bermuda introduced tailored legislation designed specifi cally to address the ILS market. The existing classes of licence for traditional reinsurance vehicles weren’t suitable for these securitised vehicle structures. Bermuda’s special purpose insurer (SPI) licence recognises features of ILS transactions which typically involve sophisticated counterparties, fully collateralised exposures and comprise a single underlying transaction. The SPI framework facilitates speed to market, minimises capital requirements and has less ongoing regulatory intervention.
Carne: This is a great example of the strong relationship between the Bermuda regulator and the commercial market. A working party was formed to look at ways in which Bermuda could improve its offering to the market and what needed to be done to make it more competitive internationally. The result of that was the SPI legislation and more recent feedback from industry regarding the level of regulatory fees. This resulted in fees being cut almost in half.
How do you see the pipeline of SPIs?
Carne: Bermuda is now proving to be the jurisdiction of choice for new transactions. Historically, Cayman was the leading domicile, and transactions that were historically based there are still rolling over, but we may well see some migrations to Bermuda. This is in response to the SPI framework, Bermuda’s broader reputation as a leading reinsurance centre with high quality regulatory standards, and the depth of the commercial reinsurance market. A number of ILS funds are also being formed in Bermuda, presenting a further means for capital to enter the market. Bermuda has always dominated the sidecar market.
How else is Bermuda positioning itself to compete with Cayman?
Carne: Bermuda is the obvious and natural home for these kinds of vehicles because we have the commercial reinsurance market here. The depth of infrastructure and expertise for catastrophe reinsurance is better than anywhere else in the world. All that talent is within a square mile, which makes for ease of doingbusiness. That is borne out by the fact that new vehicles are coming to Bermuda.
The ILS market has attracted considerable interest of late. Do you expect capital that had previously sought a home with successive classes of reinsurers now to seek to provide capacity in the ILS space?
"A working party was formed to look at ways in which Bermuda could secure a larger share of the market and what needed to be done to make it more competitive."
Carne: There’s a lot of discussion about that in the market at present. It would largely depend upon the size of the event. If we have a true market-dislocating event and there are sufficient levels of distress suffered by the traditional reinsurance players, then we may see some new entrants. The constraint here, is depth of human capital, whether there are sufficient management teams available. Lesser, but not insignificant, events are likely to prompt sidecars or cat bond activity. I think we will see largely “bolt-on” capital in response to events which also allow capital providers an easier exit when markets stabilise. I do not envisage a new class of 2001 or 2005, in terms of numbers of traditional new entrants, at this time, but I could be proved wrong!
Do you expect investor interest to continue into 2012 and 2013, and can the ILS expect a levelling off of interest, or a drop, when the wider capital markets finally rebound?
Smith: ILS may be a an opportunistic play for some, but there are several benefits to this market that will drive continued interest from both investors and those wanting to transfer risk regardless of what is happening in the capital markets. If you consider current pricing and the soft market, we are seeing a number of sponsors looking to take advantage and lock down rates for a two to three year period. Investors are seeing this as an opportunistic way to deploy capital and get a meaningful return, while traditional reinsurers are less attractive than in the past given that they have diversified portfolios rather than pure catastrophe risk.
Carne: I’m a firm believer in the future of the ILS industry. Institutional investors are more accepting of the fact that ILS is a diversifying play and that will continue to be the case. I expect the ILS market to continue to grow. Where it is becoming more opportunistic is that some reinsurers are investing in cat bonds rather than writing the business through traditional reinsurance. For larger institutional investors, the risk-return profile is better than they would be able to get in a number of more traditional products in wider capital markets.
What is the main driver of issuance volume at present?
Carne: The soft market is a definite factor. Sponsors like the opportunity to lock in the price at a cyclical low for a few years and protect their balance sheet from a hardening of the market. Some sponsors like the greater certainty associated with having the reinsurance collateralised, so that the money is definitely there forthem to draw down on when losses occur. I’d also like to think that sponsors want to grow and develop this market—to make it work they really need to participate.
Do you think that once companies get involved in the ILS space they will return again and again, creating a momentum for the market?
Carne: The California Earthquake Authority’s (CEA) bond was a classic example of this, with the ILS designed for repeat issuances. A number of players have done that: Munich Re with its Queen Street vehicles is just one prominent example. The entrance of quasigovernmental organisations such as the CEA and Citizens should help to grow repeat issuance going forward.
How important is appropriate governance to the further development of the ILS market?
Carne: The success of any market is largely dependent upon the quality of governance. If you look at the traditional capital markets and what happened after Enron, everyone involved has been working hard to restore investor confidence. A lot of investors are focused on making sure that the level of governance is appropriate for the sector. Although it adds a small cost, investors are looking for a wellqualified board, capable managers and appropriate auditors to be inplace. While strong governance is important when everything goes to plan, it is vital when something does go wrong and you need good corporate governance that service providers are in place in order to be able to navigate a route through the crisis. Similarly, for indemnitybased deals investors want confidence around claims submitted for payment by the sponsor and we have acted as claims reviewer on a number of deals to address this.
Jason Carne is a partner, insurance at KPMG. He can be contacted at: email@example.com
Adam Smith is a senior manager, insurance at KPMG, Bermuda. He can be contacted at: firstname.lastname@example.org
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