11 April 2013ILS

Acquiring a taste for cat

The insurance-linked securities (ILS) industry has experienced a buoyant few years, witnessed by a near-record issuance of cat bonds in 2012. The low interest rate environment and troubled investment returns elsewhere have helped to pique investor interest, with the markets increasingly comfortable about adding cat risk to their portfolios. This confidence has in turn helped to change the make-up of typical investors in the space. As Tim Tetlow, president and chief operating officer at ILS Capital Management explained, the investor set has matured to one that contains more dedicated ILS funds and pension funds seeking to get involved in the space. William Pollett, president and CEO of Blue Capital concurred, adding that a wide range of potential investors are intrigued by the attractive margins and yields which are uncorrelated to other asset classes.

Citing figures from Swiss Re, Stefan Kräuchi, partner at ILS Advisers said that dedicated funds were increasingly dominating new issuances and accounted for 61 percent of participation in 2012. He added that asset managers and pension funds are also making up a larger portion of ILS investor nowadays—accounting for 17 and 14 percent, respectively. Reinsurers appear to have been the major leavers, said Kräuchi, their share of the market declining from 13 percent five years ago, to 1 percent today. However, with many reinsurers now actively involved in the management of third party capital, their involvement in the space had changed rather than disappeared.

But while demand for cat bonds may well be gathering momentum, supply will constrain a potential boom in the market. As Pollett said, “there is massive potential demand, but simply not enough supply”. New issuances tend to end up with existing players, he said, leaving new investors struggling to source new bonds. Banks and ILS advisers have been “keenly trying to source new product”, he said, but there remains only a limited supply of issuers. The costly and complex nature of these deals make them a strong fit for big insurers, the largest pools and associations and state-backed funds, but “once you get past the group of 30 or so top global buyers, interest really drops off”, said Pollett. Until the market can encourage the participation of the next level of global players, issuance is likely to lag behind demand. But investor appetite is unlikely to be sated any time soon. This supply and demand imbalance is currently pushing spreads on new issues well below the technical price a professional reinsurer would expect to be paid to assume the risk. This imbalance may be good for issuers in the short-term, but explains why investors are looking for new, deeper avenues to access natural catastrophe risk, explained Pollett.

Interest piqued, but not peaking

Helping to drive much of the interest among those less au fait with the nuances of re/insurance is the uncorrelated nature of cat risk. With the capital markets having had a torrid few years, investors are happy to add a diversifying play to their portfolio, with Tetlow citing industry research by investment adviser PIMCO that found that since 1992 only one triggered bond correlated with the wider capital markets—and that was as a result of the September 11th terrorism attack. In a large, diversified portfolio adding cat into the mix therefore makes perfect sense. And with the prospect of cat bonds moving lower down in the programme and into more diverse geographies, their attractions as diversifying plays are only likely to deepen for capital market investors.

Kräuchi added that one of the key attractions of the instrument is that cat bonds are liquid and can be traded in the secondary market. He said that for investors still smarting from the fall-out of the financial crisis “liquidity is still key”. However, Pollett noted that although it was possible to trade cat bonds, they largely remain a buy and hold strategy for most investors. And with three dedicated funds accounting for a significant portion of the market there are limitations to how liquid the market can be. Cat bonds do however “benefit from regular pricing updates from multiple sources”, said Pollett, which enables the market to better understand such instruments and, importantly for certain investors, ticks the boxes on regulatory compliance checklists. Tetlow also spoke of the “trust” created for some investors by the involvement of rating agencies and modelling firms in cat bonds.

The potential returns offered by cat bonds are also attractive, particularly as there are few alternative yield plays out there in the fixed income market. While some cat bonds may satisfy hedge fund appetite “returns with a two in front” are non-existent in the cat bond space currently, these kinds of returns are likely to be available only post-event when capital is needed to support markets in distress, said Tetlow, however these types of returns are found in alternative methods of accessing catastrophe exposure such as sidecars or through funds that focus on retro or reinsurance investments. A number of recent bonds may be a better fit with institutional investors looking for a more conservative risk:return profile.

Pension funds are rising players in the ILS space, with Pollett citing a reasonably typical recent meeting during which a pension fund announced they were considering allocating 2 to 3 percent of their portfolio to the asset class. With many pension funds targeting inflation plus 6 percent, they are turning to the ILS market to help achieve such returns. But even a few percentage points of global pension fund investment would overwhelm current cat bond issuance. There are however alternatives to cat bonds that offer similarly buoyant return profiles such as Pollett’s Blue Capital, offering investors LIBOR plus 10 percent. Tetlow concurred, explaining that outstanding cat bond issuance of approximately $17 billion was dwarfed by the traditional reinsurance market, which globally purchases between $300 and $400 billion of protection annually. In his view this represents a far more attractive opportunity set for investors as there is more investment choice, greater ability to create diversity for a given level of targeted return and the ability to outperform based on investment selection compared to a cat bond-only strategy.

Addressing likely interest, Kräuchi said that return expectations have to be “in line with investor’s risk tolerance and liquidity needs”, adding that those looking for double digit returns have to be able to sit out “significant downside deviations”. He said that European and Japanese investors are happy with more conservative returns of LIBOR plus 4 or 5—that stack up well against other instruments in the current environment—but indicated that limited opportunities outside US wind had restrained growth in more conservative instruments.

It is clear that there have been few better times to attract investors into the space, but education of investors remains key. As Tetlow explained, “you really need to get the client to think laterally, as cat risk is not an easy place to start any discussion with investors”. Kräuchi agreed that “in a pitch to new investors key elements are a thorough understanding of the asset class as a whole including its benefits, but also the underlying risks”. Tetlow added that it is important to discuss key differentiators across products in the market to ensure the products investors opt for are a good fit. “Investors should think of this is a long-term, capital intensive play,” said Tetlow. And with an increasing range of products and players active in the space, investors will need to evaluate their choices with care.

It is going great guns at present, but many question whether the ILS market will face a decline in investor interest following a sustained improvement in interest rates. Tetlow said that it is a complicated picture where some investors are keen on LIBOR-linked products as their performance compensation is linked to the excess returns over LIBOR. However, the sponsors of cat bonds also need to be comfortable with those investments backing the cat bond being held in LIBOR-linked assets, said Tetlow. With growing interest from pension funds in the space, it is likely that there will still be sufficient demand from the non-correlating aspect of the asset class to outweigh the substitution a shift in the yield curve may prompt, he added. He agreed that interest rates are only part of the formula—with investors looking closely at total returns linked to return on risk—but was confident that much of the current interest would remain. Markets have evidently acquired something of a taste for cat risk and those in the sector are confident it will be sustained.

A finger on the trigger

Addressing trigger types and their relative merits for investors in the ILS space, Kräuchi said that index-based deals are probably the most popular with investors due to their transparency, but both Pollett and Tetlow warned that such triggers are not necessarily the best fit for issuers or investors. “Rather than reflecting good underwriting decisions taken by the underlying re/insurer, such instruments take a view of the market. They may be transparent, but they mix the good with the bad,” said Pollett. It is through leveraging the underwriting expertise, systems and relationships of reinsurers that manage third party capital, that investors can really gain value, he said. Tetlow added that industry-linked instruments had in the past proved popular, but that investors are increasingly willing to participate in indemnity-based triggers.

However, instruments that track the market have performed well “under a risk-adjusted comparison”, said Kräuchi, but he indicated that there are presently no instruments that “simultaneously track ILS, cat bonds, private transactions and industry loss warranties”. This looks set to change however with ILS Advisers planning to launch a fund that tracks the market later this year.