ILS: a question of balance
Many reinsurers view the cat bond market with scepticism, even mistrust—a rival product to traditional reinsurance—but as Aditya Dutt, senior vice president at RenaissanceRe Holdings, president of RenaissanceRe Ventures and the man heading up RenaissanceRe’s portfolio of strategic investments and insurancelinked securities (ILS) explained, for RenaissanceRe it is viewed just like any other form of risk transfer. “If our clients wish to purchase reinsurance protection through the cat bond market, we want to have the ability to help them.” Taking such a client-centric approach, the reinsurer does not take a view on cat bonds versus traditional reinsurance; rather it works with the customer to “see what structure works best for them”. And under particular circumstances, cat bonds may well emerge as the best fit for a particular client’s need.
As Dutt said, it is “all about the underlying risk” and how the various instruments stack up. RenaissanceRe prides itself on its ability to price risk based on the exposures that the firm accepts, with such an approach equally applicable to cat bond and traditional reinsurance transactions. “Structurally, cat bonds differ, but as long as the structure is sound, the underlying risk is looked at in exactly the same way,” he said.
RenaissanceRe views the decision to opt for cat bonds in purely economic terms. “We prefer to say: if the price is right, don’t discriminate,” said Dutt. It is all about “matching the right risks to the right capital. We don’t believe in a one-size-fits-all approach to capital”. If cat bonds are a good fit for their client’s needs, there is no reason they cannot complement traditional business.
For Jay Bullock, chief financial officer at Argo Group, the company’s approach to the cat bond market is rather similar. With 90 percent of its business written within the primary market, “ILS simply represents another form of reinsurance that broadens our avenues to capacity”. Argo is an active buyer of both reinsurance and ILS, Bullock said,with such an approach offering an “alternative to capital”. As he indicated: “reinsurance is an extension of capital; while ILS is an extension of forms of capital.”
Addressing whether he regarded ILS as a competing product to traditional reinsurance, Bullock said “At times it can be” – it’s often a complementary product but it really depends on where and when it’s used. But as he indicated, having more alternatives for “outward reinsurance protection” would always be welcome.
Dutt, for his part, said that the issue is “how these products fit within a rated insurance balance sheet”. Whereas an A-rated insurer with $1 of capital can lever its rated position to write $3 of limit, cat bonds simply don’t allow re/insurers to lever their capital. “This creates a natural tension for traditional reinsurance companies”—a tension that discourages some firms from participating in the market.
Playing the market
RenaissanceRe has, to date, restricted its involvement in the cat bond space to that of an investor. Dutt indicated that the company intends to further develop its position as an investor, but said that RenaissanceRe is not presently considering sponsoring any deals. “Currently the only side of the coin we play on is as an investor.” Bullock spoke in a similar vein, indicating that Argo is involved in cat bond trading only “in a limited way”. He said that Argo was not “very active buying and selling cat bonds, although trading is something that we are considering”.
As an investor RenaissanceRe “manages a portfolio of cat bonds inhouse on our own balance sheet and we modulate the amount of capital we deploy to this effort to the opportunities that are available in the market”, said Dutt. The reinsurer employs similar modelling techniques to evaluate the underlying risk as it would for traditional reinsurance, the major difference being the ability to trade the bonds in the market. This capability has encouraged RenaissanceRe to strengthen its trading capabilities and relationships within the market—significant factors in what is a “liquid trading market”, he said.
"RenaissanceRe prides itself on its ability to price risk based on the exposures that the firm accepts, with such an appraoch equally applicable to cat bond and traditional reinsurance transactions."
Part of any play as an investor is taking advantage of the liquidity of the market to trade cat bonds. “On occasion, and based on how our overall portfolio of reinsurance is performing and how it is using capital, we rely on the liquidity of the cat bond market to trim or add to our portfolio”, said Dutt. Although RenaissanceRe is “largely a buy and hold player”, this ability to add or shed risk “is a situation that is frankly difficult to do in the traditional market” and is an attractive characteristic of the cat bond market for RenaissanceRe and those involved in the space.
Bullock, however, was more bearish when characterising the market. “You get relatively small offerings in a reasonably concentrated number of hands with a limited number of market-makers. Such a situation defines a market that is not all that liquid and doesn’t tradethat well”. He argued that this is the nature of “early stage capital markets”, although he argued that in time greater liquidity will come to the ILS market as it grows and matures.
2011 was an active year for catastrophe events and a number of cat bonds were triggered. The Tohoku earthquake, for example, triggered two cat bonds and events globally proved something of a test for the cat bond market. That said, Dutt argued that in 2011 cat bonds “responded largely as advertised”. He said that this was in stark contrast to 2008, a year in which cat bonds sponsored by Lehman Brothers were hit—not by catastrophe losses, but by counterparty exposures relating to the firm’s bankruptcy. The event damaged trust in such instruments, but since 2008 “structural advancements” have been introduced to steady the market. Since then the market has become increasingly sophisticated, with a growing numbers of issuers, investors and products indicative of the rising maturity of the market.
Addressing the pricing environment for cat bonds, Dutt said that the market increasingly tracks that of traditional reinsurance. “If you were to plot traditional pricing—rate on line on the y-axis and expected loss on the x-axis—and plot where transactions are priced vis-a-vis cat bonds, there would be a definite curve fit there.” For Dutt however, the issue is not so much one of price; rather it is one of interest. As he outlined: “the real question is: how attractive are these securities to a broad crosssection of investors?” New investors have entered the market in recent years—with the likes of pension and hedge funds all getting in on the act—but due to the relatively small size of the market and the specialised nature of those risks securitised, there are limitations.
“Cat bonds tend to attract investors who know and understand the underlying risk. Investors that participate in this market tend to be fairly savvy”, said Dutt. David Burns, Bermuda country head at Schroders concurred, adding that one of the key issues facing the cat bond market is promoting wider understanding of the product. “Increasingly investors are looking for diversifiers to their traditional portfolio, but an impediment to greater take-up has been the fact that insurers and asset managers speak a completely different language”. This ‘language barrier’ has stymied involvement in the space, Burns said. “Many asset managers do not fully understand where the asset class sits in the portfolio—is it a fixed income security, a debt security or an equity security—it is a difficult to define and therefore find an owner for a cat bond”. That said, he added that there is “room in any multi-asset portfolio for cat bonds and ILS in general”. This tendency means that reinsurers and those with re/insurance experience continue to make up a good chunk of the investor base, although this base has widened over time.
One of the major criticisms levelled at the cat bond market is that it remains somewhat limited in its geographic scope but, as Bullock, Burns and Dutt explained, it simply reflects the make-up of the wider re/ insurance market. Dutt indicated that over time, as insurance penetration deepens in places such as Asia and South America, there will be a “natural broadening of what’s out there in the market”. For now, however, its focus will be upon more traditional geographies. As Bullock indicated “intermediaries in the market are constantly clamouring for new risks”. However, the issue remains that global reinsurers’ pursuit of business internationally has “kept a lid on rates”. Until insurers and reinsurers can achieve adequate returns in international geographies, it will be unlikely that risks will be laid off to non-traditional markets, Bullock said. Until this situation changes, it seems that the US and its risks will remain the most attractive and active in the space.
A further significant impediment has been the lack of model data in developing geographies. “Modelling is simply not robust enough in other parts of the world. When looking to link a cat bond to something like Philippines earthquake, you find that the vendor models simply do not have enough data experience to create and evaluate risk,” he said. This data shortfall means issuing cat bonds and attracting investor interest remains difficult outside well-modelled regions with a history of loss data. Until emerging markets develop, it seems that European and US risks will continue to dominate the market.
"You get relatively small offerings in a reasonably concentrated number of hands with a limited number of market-makers. Such a situation defines a market that is not all that liquid and doesn't trade that well."
Key to further development—by both geography and investor— will be “an increase in issuance volume” and a more liquid market. With only around $12 billion of cat bonds in the market, it has been difficult to attract the kind of institutional investors that could really help grow the cat bond market.“To make this product ‘democratic’, what we really need is for the big fixed income funds to play,” Dutt said, although he admitted that their involvement would remain limited by the volume of the market. Burns said that the limited scope of the market had served to lessen its appeal to investors. A key concern for those considering cat bonds has been “limited opportunities to spread risk within the space”, he said. This remains a concern with US and natural catastrophe risk predominating, although as the ILS market develops, one would imagine that this will become less of an issue.
An increase in volume would help, encouraging trading, and as Dutt explained, “liquidity attracts buyers and sellers”. For the time being, however, the market’s “liquidity reflects the small spread of the market—it is liquid on paper, but if you need to move a big position, then the liquidity is compromised”. Until this situation changes it will be difficult to get the large pools of capital participating. “Increased trading liquidity—potentially through exchange trading” and great issue volume will be needed if the industry wants to take its ambitions to the next level, Dutt said. Until then, the market will remain largely niche.
Burns suggested that ILS funds that “cherry-pick favourite ILS issues to create a more diversified fund” would help to bring the cat bond market “closer to a genuine retail investor base” and enable it to move away from its present limited investor base. Such an approach is already being taken by firms such as Credit Suisse, but Burns said that there continues to be an emphasis on institutional investors in the ILS space. Until there is greater emphasis on promoting the product in the wider market, he said that interest would remain limited. Burns added that at the same time projected returns on ILS and cat bonds “aren’t amazing. Investors can expect to achieve similar returns from a high-yield bond fund”—a factor that will likely discourage many from dabbling in an area in which they have still limited knowledge.
Looking ahead, Dutt said that there are “encouraging signs” in the cat bond space. New and repeat issuers are on the rise and the volume of bonds issued continues to increase. At the same time “more issuers are thinking of cat bonds as viable means to protect their balance sheets and more investors are looking at the asset class as a way to participate in the market”. Such an outlook should encourage greater volumes and liquidity. Being a “non-correlated risk to the wider financial market” has also helped, with “one of the silver linings of the financial crisis being that it showed the cat bond market to be a largely non-correlated asset class”. Whether major institutional players will consider the market large enough to warrant their attention remains to be seen. Dutt admitted that “practically speaking there will inevitably be limitations to their involvement”. Nevertheless, re/insurers such as RenaissanceRe continue to play an active role in the cat bond market.
Bullock argued that in terms of future development “all the tools are already on the table”. He said that the market will inevitably grow in sophistication, extending new and specialist products to the marketplace. Appetite and issuance will however “depend on traditional capacity and how people react to the low interest rate environment. With returns just not acceptable in the core business there could well be a squeeze on capacity, particularly the further out you go on the risk curve”. This could well present significant opportunities for the ILS space, but Bullock said that he is “not bullish yet”.
Asked about RenaissanceRe’s future involvement within the space, Dutt was circumspect, saying: “We will continue to be involved in the cat bond market in the future, with a focus on increasing the breadth of services we can offer our clients.” Cat bonds are, with time, cementing their position as a viable vehicle for risk transfer, but as Dutt made clear, they will inevitably remain a niche and complementary addition to the reinsurer’s more traditional arsenal.
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