ILS: cannibalism or evolution?
Bermuda is very much at the forefront in the development of insurance-linked securities (ILS), with a host of Island players active in the space. From a running start back in 2008–2009, when new special purpose insurer legislation was implemented by the Bermuda Monetary Authority, Bermuda has established a leading position within the ILS market. As Arthur Wightman, partner and insurance leader at PwC, Bermuda indicated “it is hard to dispute Bermuda’s pre-eminent role in ILS—with innovative and well-established reinsurance and investment marketplaces, as well as a practical regulator and stock exchange, service providers and most important, the intellectual excellence it is so well regarded for—capital ﬂows have come en masse through Bermuda recently and look set to continue.”
And 2012 has been another bumper year for ILS. Issuance and debate regarding its potential as an increasingly signiﬁcant complement to the traditional reinsurance market has been riding high. A host of Bermuda and global players are involved in the space and despite suggestions of a competitive dynamic, there seems a grudging acceptance that alternative plays and the involvement ofthe capital markets are here to stay. Issuance and interest has been on a general upward trend for some time, but interest has risen markedly of late, driven by a number of factors.
Wightman described the sector as a “hive of activity recently”, with rising investor interest in the space and the hunt for diversiﬁcation in risk transfer being the main drivers of rising issuance. Wightman said that the ability to enter and leave the market quickly and with relative ease, compared favourably to more traditional reinsurance investment, attracting capital players keen to invest in short-term plays. He said interest had risen as asset managers have sought uncorrelated risks in the face of the wider economic downturn, with ILS an attractive admix to traditional capital market portfolios. Returns on ILS products are also seen as attractive at present—particularly considering low yields in the wider market—he said, but warned that these are nevertheless “risk-rated returns”.
Wightman added that on the sponsor side, “risk managers are always looking at better ways to diversify the risks they are transferring from their books”, with ILS representing an increasingly popular complement to traditional reinsurance. This has given risk managers the opportunity to “balance the risks that they transfer across products in order to better manage their risk down”. He highlighted the success of Citizens Property Insurance’s Everglades Re Bermuda cat bond, which enabled the ﬁrm to place $750 million of coverage—half its total budget—in the ILS market. He said that for primary insurers such as Citizens, ILS products can offer a counterpoint to the “cost and capacity limitations of reinsurance”, particularly when capacity is constricted post-event.
Further aiding the ongoing success of the market will be its “track record and established history of issuance”, said Kent David, vice president of consulting services at Eqecat. He said that rising volumes had helped generate greater interest and cemented the reputation of the market in the eyes of the wider capital markets. Much of this is linked to the “demonstration of orderly settlements following global disasters, which have helped to increase the faith in, and understanding of, these products and demonstrated that risk analyses are robust and the instruments reliable”, he said.
David added that improvements in capacity modelling, which enable the industry to better understand such issues as the description of risk and the type of attachment, will enable the market to function more effectively. Finally, he indicated that the development of risk modelling ﬁrm, Perils in Europe, which applies a neutral, consistent methodology to describe exposure as well as industry loss has aided the market in its knowledge, understanding and application of risk transfer.
Wightman added that liquidity would be key to future market development, and said that the market is at “a tipping point—in terms of product offering, awareness and efﬁciencies—at which the sector can attract a broader spectrum of investors into the space”. He highlighted the industry-loss warranties sector of the ILS space as one to watch in terms of attracting broader investor support, arguing that they are “relatively straightforward, are in a liquid market and tend to provide good access to pricing and returns in the latter half of the year”.
Rather than a ﬂash in the pan, it seems that interest in the ILS space isn’t going to go away any time soon. In fact, market statistics show a slow, upward climb in issuance. And talking with Paul Schultz, CEO of Aon Benﬁeld Securities, he indicated that he did not believe that there was a ceiling for ILS issuance. Wightman was equally bullish, adding that one leading asset manager recently predicted the market would double in size in the coming years. He said that ILS account for around 14 percent of property cat capacity now and if it rose to around 30 percent—“and there has been no glass ceiling observed yet”—it would represent a sizable chunk of the market. David likewise indicated that interest in ILS products would be sustained, with the “diversiﬁcation of available risks set to further increase the market’s potential”.
Schultz added that a further push would be derived from “rising interest in transferring risk and volatility into the alternative market as demand from underlying clients for peak capacity continues to increase”. He said that in the case of both ILS and traditional reinsurance, “all these markets participate to meet underlying demand”—and it does not seem about to go away any time soon.
David did however add that there may be a limit to investor capital, but stated that it was not a function of the market, rather a reﬂection of the options available in the wider capital markets.
Wightman said that he foresees a market in which both traditional reinsurance and alternative products will work side by side. “There is a synergy between ILS and traditional reinsurance that allows them to complement one another,” he said. Wightman indicated that risk managers will probably look for a mix of risk transfer options in future, with the ceiling for ILS likely to be dictated by market conditions. David added that where there is “competition with traditional products, cedants will look at pricing closely” and it would seem that when ILS products can compete on price and offering, they will provide an attractive alternative to more traditional forms of reinsurance, but not necessarily a replacement.
Better in than out
The question then becomes: will the dynamic erode the position of traditional reinsurers? David and Schultz were optimistic about the potential for a cooperative evolution. “It will be a happy partnership,” said David, “one characterised by both competition and evolution.” He said that competition would evidently form part of the dynamic as cedants sought the best price for their coverage, but added that ILS products ﬁt with reinsurers’ “need to diversify”, while providing them with opportunities for involvement. Schultz said that Aon Benﬁeld views the relationship as complementary, with the broker appreciating the ability to discuss the “whole spectrum of capacity with clients”. He added that the ILS market has generated efﬁciencies associated with multiple markets, further strengthening the wider industry.
Kean Driscoll, CEO of Validus Re—which has been an active participant in the ILS space for some years—said that while in “some instances Validus Re sees third party capital competing directly with its traditional offering, it also presents the opportunity to bring solutions to the marketplace in times of dislocation, or in areas where Validus Re does not have a huge net appetite”. He said that the company’s approach was a pragmatic one—“if capital needs to come into the marketplace, we need to ﬁnd a way to capitalise on that, or else ﬁnd a way to effectively compete with alternative forms”.
Validus Re has taken a pro-active approach to the ILS segments, sponsoring and managing sidecar capacity since 2006. The company’s current managed vehicle lineup includes a series of AlphaCat Re entities which write collateralised reinsurance and PAC Re—a Class 4 joint venture reinsurer established in 2012 with hedge fund Paulson & Co to offer more traditional, rated reinsurance— extending further capacity in the ILS space. Driscoll said that Validus Re’s position in the ILS space “has evolved across a spectrum of products—not only do we offer traditional managed funds, akin to what independent third party managers do, but we have also managed multiple sidecars from our earliest days”.
He said that Validus Re’s approach has differed from that of many reinsurers, with the ﬁrm choosing to “align AlphaCat and its other ILS offering directly with Validus Re”. Driscoll said that such an approach enables Validus Re to apply its world-class human capital and analytics to understanding the nuances of ILS products and perils, as well as build on those close relationship it enjoys with insurers and the capital markets. “Thanks to our positioning, we are able to tell investors: you don’t have to chase that narrow market of single-shot business. We enjoy relationships across the breadth of the market to source potential ILS opportunities.” Such an approach enables Validus Re to extend reinsurance solutions to insurers and the capital markets across the full spectrum of products, creating a compelling case to potential cedants and investors. Validus Re’s approach to ILS—one characterised by a positive, collaborative approach—may not be the most common form taken by the market, but indications are that others will follow in its wake, leveraging traditional reinsurance capabilities in pursuit of rising levels of ILS business.
Wightman predicted that the industry would see more traditional players “establishing complementary businesses that under the umbrella of their overall group will provide ILS as an alternative to traditional reinsurance in the more commoditised or efﬁcient areas of the property catastrophe marketplace”. This would play well with the rating agencies and asset managers interested in the space as they look to the convergence capabilities of reinsurance ﬁrms. Wightman added that he also expects to see more alternative players such as Nephila and CatCo enter the market, offering specialised ILS capacity. Wightman did however indicate that there had been a lot of discussion regarding sidecars acting as direct competition to traditional reinsurance and impeding the 5 to 10 percent rate increases many had sought at the last renewals. “The word cannibalised has been used an awful lot,” said Wightman, but he argued that the fee dynamic associated with these products “often more than offsets any erosion in the traditional book, and is still value accretive” for traditional players. Reinsurers look set to increase their involvement in the ILS space. To do otherwise would seem like missing the train. Furthermore, Wightman added, “I would expect the broader reinsurance market to continue to do what it does best, namely in pushing the frontiers of risk transfer, reinsuring risks that traditionally they did not or could not do before, while exploring the huge growth potential in the emerging markets, whether that be through risk transfer or risk ﬁnancing deals.
Structuring the fundamentals
One of the most important elements of ILS is the structuring of the product. Ease of understanding and the availability of appropriate data are central to the success of the sector. As David made clear, “structuring is critical—the disclosure and description of risk provides the ability to trade risk in a rational manner. Without a good description of risk, the trading of it between unequal partners vis-a-vis their knowledge of the data is difﬁcult”. He said that modelling and models provide the basis for that understanding and that they therefore play a crucial role in the creation and transparency of ILS products. “Eqecat feels the role of the modelling agent is to be a neutral adviser and describer of the transaction,” said David. Schultz concurred that the “structuring and transparency on these deals is critical”. He said that as new investors enter the ILS market, they are looking for a “high degree of comfort, that there is transparency around the risk and that the structures have been built in a fair and equitable manner”.
Wightman similarly argued that the structuring of these products is “pretty fundamental”. He said that in recent years ILS products have become more standardised and that “as you get more of them and people get better practised at delivering them” their popularity has grown. “The more you do these products, the more efﬁcient, transparent and simpler they become. The capital markets are looking for efﬁciency—not complexity and large costs—so structuring for the capital market investor is important.”
Addressing the essentials of structuring the ILS product, Schultz said that there were two very important nuances to structuring— one that is client-centric, the other that is investor driven. On the client side, “the product has to respond to the underlying risk portfolio as much as possible, whether that is through indemnity structures or a highly structured deal that minimises basis risk to client. As we increase penetration of these products, we have to adequately answer this question.” On the investor side, Schultz said that transparency would be key, with capabilities on the underwriting and modelling side helping to instil further conﬁdence in the ILS product.
Wightman likewise spoke of the need for “better risk insight”. He said that a lack of information had always been a challenge to effective underwriting in the ILS space, but that as data knowledge improves, so investor and sponsor conﬁdence will rise. “Simplicity will be key to this,” he said. Wightman said that the industry needs to create products that are ultimately attractive to the capital markets. The speed that ratings are provided today has helped, he said, as has the general regulation of these products, meaning it is now far easier for investors to “get their hands around these products”. Wightman said that investors are looking for “diversiﬁcation, yield, speed to market, efﬁciency of product and transparency.” The modern ILS market is increasingly meeting these needs.
David concluded that with ILS products traditionally trading out on the tail, there were four characteristics for structuring that need to be borne in mind. The ﬁrst of these is “robust modelling of the tail—these are low probability-high severity events and it is essential that the models capture both black swan events” and less catastrophic exposures. Second, models must include a “stable representation of the temporal constraints of the bond” so that there is no confusion regarding its application and trigger. Third, the ILS market needs to be able to handle and extend to clients a range of trigger types and features in order to provide depth and optionality to the market. Finally, the ILS space needs to show its ability to evolve to market conditions and demand, particularly as regards the disclosure of risk.