Convergence investors: an evolution
The options for convergence investors have deepened over time, and with new risks being brought to market with increasing frequency, it is apparent that investors, their appetites and their deployment of capital are adapting to a new norm.
Institutional investors continue to dominate the space, with pension funds taking over from hedge fund and reinsurance investors as the leading players, as returns in the space have come down.
Luca Albertini, CEO of Leadenhall Capital, estimates that around 90 percent of his investors are pension funds and although he agrees that this does not necessarily reflect investor appetite right across the convergence spectrum, it does provide some indication of the strength of pension fund involvement in the space.
Michael Pinsel, partner at Sidley Austin, concurred, adding that while a lot of the money in the space is fronted by specialist investors, a significant amount of the capital behind those funds is pension money. He said that in the past there was greater hedge fund involvement in the convergence space, but that following the 2008 financial crisis “hedge funds had their own issues to address, and many chose to refocus on their core investment strategies”, drawing back from the convergence space.
In the meantime, pension funds “had gone through the educational process and had come to increasingly understand the value of insurance-related assets,” said Pinsel. He explained that diminished fixed income investment returns across the broader financial markets had succeeded in making insurance-linked securities (ILS) more attractive on a relative basis, while pension funds had come to recognise the diversifying benefits and lower correlation of insurance as an asset class.
“As the ILS market has matured, the premium built into the investment return relating to the newness of the asset class has diminished and more cautious investors have moved in from the sidelines”—in this instance, the pension funds.
“There is recognition that the ILS space is a market of durability and the cautious lead time needed for full institutional acceptance of the space is beginning to pass,” explained Pinsel. Pension funds also happen to be a particularly good fit for insurance risk, he said.
“Often they don’t require the same level of liquidity as other investors,” and are therefore able to invest right across the spectrum of insurance risk. This makes them ideal investors for illiquid insurance vehicles such as collateralised reinsurance, as well as for more liquid instruments such as cat bonds.
However, there remains a section of the investor base that is looking for liquidity in its insurance risk, said Albertini. “You have some investors who can invest only in liquid securities because of, for example, regulations under the European investor directive. For those investors, assets need to be liquefiable within a week or so, typically limiting their involvement in the convergence space to cat bonds. They cannot invest in the collateralised reinsurance space,” he explained.
“This has forced some investors into the liquid pot of securitised insurance assets regardless of how attractive returns are in the illiquid pot,” and led to more marked fluctuations in investor capital in the liquid cat bond space, Albertini explained, with cat bond-only funds being obliged to open and close, reflecting the availability of securitised transactions.
“Funds typically close because they won’t take investor money when they don’t have enough liquid cat bonds they can deploy capital into,” Albertini continued. This lends greater investor weight to the more liquid sections of the market, which is reflected in the lower investor returns apparent in that section of the market—although cat bond risks do tend to be more remote, and priced as such.
Albertini said that Leadenhall Capital’s funds typically offer quarterly liquidity, but that this can prove problematic for sectors such as private banking which “post-2008 want true liquidity by choice”, while others are restricted by absolute requirements for liquidity. While ILS funds “don’t expect all their investors to want their money next month, there is nevertheless recognition of the need for liquidity”, he added. Fortunately for the market, pension funds tend to be happy with the lack of liquidity associated with certain convergence risks such as collateralised reinsurance.
Other investors meanwhile face restrictions regarding the type of risk that they can invest in. Some may limit their exposure to US wind risk, which accounts for a significant portion of the convergence market. Many funds also regard non-US risk as an attractive diversifier, although the benefits of diversification need to be considered within the context of return.
“If returns fall below an absolute level, no matter how diversifying the risks are, many investors will tend to walk away,” said Albertini.
Addressing appetite for risks within the convergence space, Pinsel said that he has seen a slight uptick in the pursuit of more risky products—“a feature not simply of a push for higher returns, but also an increased appetite for insurance risk generally within the capital markets”. He said that there is already evidence of appetite for casualty risk, with emerging risks promising the market higher returns.
Paul Larrett, senior non-life originator at Securis ILS Management (Bermuda), said that with the capital markets increasingly comfortable in the convergence space “the range of investments that people are entertaining has broadened right across the spectrum, from primary insurance right through to collateralised retrocession”.
“This is particularly evident in the US, where there is growing interest in trying to access some of the more direct insurance business—cat exposed, but more direct.” He said that changing market dynamics and softening conditions in the conventional re/insurance space had encouraged greater interest in convergence opportunities—among cedants and investors alike.
Not that rising interest has been all plain sailing. As Larrett explained, softening market conditions are making the task of sourcing attractive risk more difficult and are encouraging a broader examination of risk. “As the market softens, it’s increasingly important to have good access to business. When rates are very attractive and prices are high, more transactions will look acceptable, but when rates soften, fewer transactions will meet investor return targets.
“When this happens you’ve got to sift through more transactions and pick out the ‘diamonds in the rough’.”
Larrett said that determining the gems in the space depends very much on investor appetite, but explained that risk selection is very often dictated by two schools of thought. The first argues that with pension funds investing 98 percent of their funds in fixed income and equities, the capital they give to an ILS fund is unrestricted by correlation or restrictions, freeing the fund to pursue the maximum return for their pension fund client, he said.
The second school of thought suggests that investors will be looking at the marginal impact on their wider portfolio and that as such their approach will depend on their particular risk appetite and how risks fit within a wider portfolio. Funds will therefore have to weigh up the mix of their convergence portfolio with care.
Albertini and Pinsel both argue that the market has considerable opportunity to bring unmodelled or less well modelled risk to market in order to complement the existing breadth of risk. As Albertini explained, there is at times an over-reliance on models as the only source of information on securitised and convergence risk. He said that the industry would do well to consider risks that are not as closely modelled by the big three vendors as a potentially significant addition to the convergence market.
Pinsel added that transactions that include unmodelled risk can help to create a more diverse risk:return profile that could attract further interest into the space. “ILS funds understand that different investors are looking for different levels of risk. Specialist investors may be interested in the higher risk:return transactions that these unmodelled risks may represent.” The market is looking to bring in second and third level cedants and new geographies, and having a more open view of unmodelled perils might well help to do that, he said.
Unlocking risks currently held by governments at the federal or state level would also help to drive growth in the convergence space, said Larrett. “The US government doesn’t want all its insurance risk to lie within the wind pools, for example—it’s simply not within its interests. Momentum is gathering to take certain risks out of wind pools and transfer them into the private market.” This represents considerable opportunity for the market.
Pinsel added that the market is also looking at new ways to structure risk in order to bring more cedants into the convergence space. “There is a demand imbalance right now, with more investor money to deploy than there are risks and not enough liquid transactions to satisfy that appetite.” If the market can structure new transactions—smaller and more innovative perhaps—then it can hope to marry new risks with existing and growing investor appetite.
Albertini said that investors are also looking to encourage cedants to release riskier layers in order to hit their return targets, particularly as coupon rates have come under increasing pressure.
A certain maturity
Looking ahead, Albertini said that there is an expectation in some quarters that a major loss would help to pep up the recent decline in investor returns, but he explained that many would be left disappointed. “Rather than prompting a change in pricing, a major loss will likely encourage money that is presently sitting on the sidelines to enter the space, while most investors will be tempted to reload to take advantage of any—in all likelihood, temporary—dislocation in the market.”
What is more likely to shake up the market is an unexpected loss, said Albertini, citing the Thai floods as a case in point. This might help to create a change of attitude, although it is apparent that there is already a change in investor appetite as returns have come under increasing pressure.
“There is still a net increase in capital entering the sector, but the pace has slowed,” explained Albertini. The change is indicative of a growing level of maturity in the convergence of the insurance and capital markets, but it may well not be welcomed by all.