Bigger and increasingly refined
The ILS market had a stonking year in 2013. Here, we talk to leading participants in the market and get their thoughts on the state of play and likely heading for the sector.
The year 2013 was very nearly a record one for ILS issuance, with $7.1 billion of bonds issued over the 12-month period as investor interest flooded into the market and cedants grew increasingly comfortable with, and confident in, the ILS concept. And the market can expect much the same in 2014.
As Paul Schultz, CEO of Aon Benfield Securities, made clear: “We are bullish on the space. There is a good level of bonds maturing this year, which will release capital to redeploy into new transactions and we expect a good percentage of existing deals to renew.” 2014 is likely to follow the successes achieved in 2013, he said.
Schultz said that Aon Benfield Securities expects between $7 and $8 billion of cat bond issuance in 2014, with $100 billion of convergence capital entering the wider market over the next five years. He predicted that the rate that collateralised capacity will enter the space will quicken, with demand remaining strong for alternative capacity. “The number of ways investors and insurers can participate is growing and this can only be healthy for the market,” he said.
Bill Dubinsky, managing director, head of ILS at Willis Capital Markets and Advisory said that Willis is similarly bullish about the market. He said that there had been substantial new money in 2013 and there is yet more new money waiting on the sidelines for 2014. He said that he anticipates the market reaching a state of ‘equilibrium’, however—with the level of money entering the sector equalling that which is leaving. He explained that the influx of capital has placed significant pressure on rates, encouraging a more cautious approach to entry.
“Pension funds and endowments would like to increase their allocation to the space, but at the same time they don’t want to flood the market with capital and chase prices down,” he said. This dynamic will moderate the flow of capital entering the space.
Michael Popkin and Rick Miller, managing directors and co-heads of ILS at Jardine Lloyd Thompson Capital Markets (JLT), added that the diversity of mandates and the lengthening track records of ILS managers should also help to increase the flow of capital into the space. As they explained: “Having more professional ILS managers who can take meaningful size lines provides additional stability to the market.”
They added that on the issuer side cedants are increasingly comfortable with capital markets capacity as part of their reinsurance strategy. “It is no longer a question of whether one should embrace convergence. It is more about how best to interact with the market.” This will in turn help to overcome the imbalance in supply and demand that exists in the space.
Popkin and Miller added that a search for capital market solutions outside property cat was also healthy for the industry. “This will allow ILS managers to play a larger role in the reinsurance and risk transfer market, which will make other parts of the market more efficient. This will enable more cedants to begin to build the valuable long-term relationships with the capital markets investors,” they explained.
Dubinsky said that the market is benefiting from increasingly flexible terms and conditions “that are meeting cedants’ needs without losing sight of what investors need in terms of evaluating risk—we have seen greater transparency, flexibility and a modest improvement in speed to market”.
Popkin and Miller added that the growth of reinsurer-backed third party capital platforms is indicative of an increasingly permanent landscape. They said that they have been encouraged by the range of investment strategies being pursued, as the asset class grows increasingly mainstream. They stated that this will create significant opportunities for growth in risk transfer, with the challenge being to “clearly identify, measure and evaluate exposures in order to get transferred to more efficient holders of such risk”.
Schultz pinpointed the move towards more indemnity-based deals as being one of the leading positives in 2013. “The bulk of buyers want to buy where they are recovering based on their actual losses, rather than a proxy for their loss.” He cited Zenkyoron’s Nakama Re and AIG’s Tradewynd Re transactions as examples of cedants moving from parametric triggers to indemnity-based deals that better reflect their risk exposures.
There remain a few challenges, however, associated with the need to maintain rigorous transparency, said Schultz, particularly as regulators inevitably increase their oversight as the market grows in size. Dubinsky concurred that the industry “can’t get too comfortable. We need to be relentless in our pursuit of excellence”.
Popkin and Miller highlighted a particular concern related to leverage in the ILS space. “As the breadth and complexity of risk transfer increases, concerns around spread compression would be an easy and simplistic area to identify. We are more concerned however about the secondary implications for spread compression, namely leverage.
“Leverage can play a valuable role. However, as we’ve seen in other markets, too much leverage or leverage taken in the wrong way or on the wrong terms can lead to problems, even when the underlying assets might be performing within acceptable parameters. As the ILS market continues to mature and as spreads on certain risks tighten, the temptation for leverage will increase. Currently the ILS thesis is focused on uncorrelated returns with other markets. As leverage increases, correlation increases.”
Diversity: by peril and scope
Schultz said that developing into new geographies will inevitably prove challenging in the face of traditional rated interest, but said that with rates of ILS transactions falling by around 25 to 35 percent in 2013, ILS capacity is increasingly attractive even for diversifying perils. He cited the entry of QBE into the ILS space with its VenTerra transaction as being an example of rising interest in ILS among cedants in diversifying geographies.
He also expects more small and large transactions to enter the market, with the Achmea Re Windmill I Re deal, which placed $40 million of risk with the capital markets, being an example of the trend. Dubinsky spoke in a similar vein, adding that while risks were “largely similar”, there was “a slight tilt towards diversifying perils and outside natural catastrophe in 2013”.
Popkin and Miller said that JLT is seeing growth in the size of both bonds and the diversity of perils. They expect more clients to tap the capital markets via private placements due to their “substantially lower bond-building costs” that help make the capital markets “more accessible to a broader range of cedants” and “increase the democratisation of capital from the capital markets”. They predict that more perils and cedants will look to the private markets, with a corresponding increase in acceptance and deal scope.
Turning to the development of trigger type, Schultz said that parametric and index deals play an invaluable role in emerging markets, but that markets will inevitably shift towards indemnity deals. He described non-indemnity deals as “helpful, but that the goal has to be towards indemnity structures”. Dubinsky differed on the development of triggers, stating that index triggers have a role that is not always transitional. “In some instances such transactions might be more efficient for cedants,” said Dubinsky. He indicated that he doubted a 100 percent indemnity-based market was likely.
Popkin and Miller were circumspect in their evaluation of trigger type, arguing that “cedants need to embrace the trigger most appropriate for the risk they are seeking to transfer”. They commented that “super-regional and single state insurance companies favour indemnity-based triggers, while global insurance companies are in a better position to take basis risk though synthetic triggers”.
Some risks may also not suit an indemnity trigger, such as losses from tourist activity and political interruption, they said, with a parametric trigger proving more appropriate. “A state agency trying to hedge the economic impact of overland flooding of a river bank to contingently finance shelters and reconstruction may find a parametric trigger with a shorter development period (such as 72 hours) more appealing than waiting for claims to get filed, accumulated, submitted and accepted by a traditional insurance or reinsurance company.”
Schultz said that there is an increasing number of reasons to be confident that the ILS sector will continue to achieve strong growth. “Long-term pension fund interest provides a lot of confidence to cedants regarding the sustainability of capital. This helps to instil confidence that the market will reload post-event and helps sustain appetite in alternative risk transfer,” he said.
Popkin and Miller concluded that 2013 proved the year that ILS went mainstream, driven by new, varied and sizable deal flow. This has in turn led to greater awareness of the asset class within the investment community and a greater level of capital for dedicated ILS managers. “Fresh capital has allowed ILS investors to participate in more areas of cedants’ programmes, with the net effect being that more cedants have begun to engage with the capital markets. We expect that this trend will continue and will accelerate.”