ILS: in pursuit of diversity
Traditionally US-centric risk has made up a significant portion of the cat bond and insurance-linked securities (ILS) market, with around 70 percent of the total convergence market being US-based, much of this to do with the consistency of US issuers.
As Luca Albertini, CEO of Leadenhall Capital made clear, issuance in other geographies has been “spotty”, with some diversifying issuers returning with the market, while others have issued transactions once, never to return. “The consistent issuers have been in the US, while other geographies have been using the capital markets a little more opportunistically,” he explained.
US risks are also those peak perils that are perhaps the best fit for the capital markets. As Ben Brookes, senior director, capital markets at RMS explained: “Re/insurers have large concentrations in these perils so seek to cede that risk elsewhere, while capital markets investors do not have these concentrations, so can take these risks on as diversifiers to a broad asset base.” They also tend to be priced in a way that is attractive to investors that regard the convergence space as a diversifying play to their wider investment portfolios.
The pricing of traditional reinsurance has also helped hold down interest in non-US risk. As Kathleen Faries, CEO of Tokio Solution Management explained, outside the US there has been plenty of competitively priced retro capacity in the market, which has meant that there has been “less interest in issuing non-US cat bonds. However, with spreads for cat bond capacity tightening there may be an increase in issuances outside of the US as the cost to issue continues to go down”.
Competitive pricing and an investor community that has increasingly got its arms around ILS look set to encourage a greater pursuit of diversification within the convergence space. As Faries indicated, with investors and ILS managers now running multiple models, there is a growing ability to analyse risks in a host of diverse geographies, while indices such as PERILS have helped investors “get comfortable with industry loss contracts outside the US”. Greater oversight in developing geographies will undoubtedly help to spur interest.
A diversity of appetites
Despite increasing diversification of the underlying risk, however, pan-Atlantic funds continue to dominate the convergence space, although “this is more the way that the ILS market has grown from funds set up and backed by insurance and reinsurance expertise, than due to a lack of confidence in other geographies”, explained Brookes. Wider convergence investors are drawn from a diverse range of geographies, with “worldwide investors increasingly comfortable with cat bonds as an alternative investment”, said Faries. Greater international interest should help to act as a further spur to those cedants and investors considering the capital markets option.
And it would seem that a good number of investors are looking for geographically diverse perils in which to invest. As Albertini outlined, many investors are looking for risks well away from those in their wider portfolios. Others still are looking for local risks that fit with their investment philosophies, with sovereign wealth funds an example of those looking for a local component to their investments.
Taking California as an example, Albertini said there are three ways that Californian investors are considering local risks placed in the capital markets: the first is that they already have sufficient risk exposure in the state and don’t want any more; the second is an unwillingness to be associated with money made from risks and exposures in the state; and the third is a desire to be involved in the development of insurance provision in the state. All three philosophies present opportunities for diversification as investors consider local and remote opportunities that adhere to their particular risk appetites.
While appetites are likely to be diverse and their drivers still more so, it is evident that the geographic scope of cat bonds and ILS instruments is expanding. One of the key drivers is the increasingly competitive market for such risks. “Tightening spreads will increase interest from sponsors in non-US territories as the cost to issue a cat bond will compete with traditional ultimate net loss reinsurance and retrocession,” explained Faries.
Albertini also spoke of improving pricing, arguing that “traditional reinsurance has been compelling vis-à-vis the capital markets. For those that have bought protection outside the US, they really needed to see the shining light of the capital markets”. Without reinstatement and sometimes without indemnity, he said, pricing has had to converge with traditional reinsurance in order for the capital markets to compete.
But it seems that recent deals such as Bosphorus 1 Re may have set a new benchmark in pricing. The deal, described as a “massive issuance” by Albertini, bottomed out at 2.5 percent, well below what has been the norm for such transactions. He said he had anticipated interest tailing off as the deal went south of 3 percent, but diversifying perils such as the Turkish earthquake in Bosphorus had evidently proved too attractive to investors.
This was largely due to levels of capital far outstripping supply, said Albertini, but he still described those pursuing the market down as likely to be receiving only “skinny money” for their participation. He agreed that diversifying perils are attractive to many ILS funds, but cautioned against taking on such products at any cost. Addressing the Bosphorus deal Albertini said that “for this reason Leadenhall preferred to allocate to other diversifiers rather than chase this issuance down to the 2.5 percent level”.
Nevertheless, Albertini said, diversifying perils were regarded as “good news” by the ILS investment community. “When a diversifying peril comes to market I see how the bond is priced to see if it can make it into my portfolio.” Albertini said that Leadenhall often pursues diversifying deals privately, not waiting for them to come to market. Evidently they are regarded by Leadenhall as a welcome addition to what has been a largely US-centric cat bond mix.
Brookes explained that such perils enable funds to “build a diversified cat-only portfolio, and reduce the returns volatility of the fund”. In a sector dominated by cat risk, diversification is certainly a welcome addition.
Brookes cautioned, however, that for those holding a small number of positions in the market, diversification is “arguably a distraction”. If ILS transactions are pursued as a diversifier, it might be better to pursue deals that offer higher returns, said Brookes, rather than ones designed to act as a diversifier for broader ILS risk. With the market currently dominated by “dedicated ILS funds seeking diversification, transactions that are viewed as ILS diversifiers tend to offer significantly lower returns than the peak risk of Florida hurricane”. Hence the interest in, and pricing of, the Bosphorus deal. Competitive pricing is likely to encourage other cedants to consider the capital markets route, opening up further opportunities for diversifying perils.
The other key driver of diversification is greater understanding around new risks being brought to market. As Brookes explained, there needs to be “a strong understanding of the risk to be covered and the ability to quantify this risk”, as well as a “robust method for settling the transaction, be that claims data, industry losses, or reported event parameters”. This applies equally to investors and issuers as they get comfortable with the data and assumptions behind such transactions.
Modelling firms will play a valuable role in building out diversifying opportunities. As Brookes explained: “Investors look to the modelling agencies to provide an unbiased and accurate view of the range of risk associated with an ILS trigger. The need to be able to model the risk is key.” As the markets take on more diversifying perils, there will be rising need for models to examine and price such risks.
Triggers will be equally important to the success of ILS transactions, said Brookes, with the most successful transactions benefiting from unambiguous and reliable triggers. Again, risk modelling companies have a role to play in this, helping to “design new triggers that are robust, with a minimum of surprises”. Understanding and improved modelling will undoubtedly spur further diversification in the capital markets.
While much has been spoken about geographic diversification within the convergence market, it is also gaining increasing traction by peril. As Faries outlined: “There seems to be an increase in activity in this area, with more interest from hedge funds looking to invest in a reinsurance model similar to Greenlight Re, Third Point Re, and now Southport Re. Clearly having underwriters that are familiar with non-cat business is vital to success in longer tail lines. As we have already seen, fund managers are hiring teams of traditional underwriters for these lines of business.”
Non-cat perils are an increasing component of the market with more life deals and even a mixed peril cat bond being issued recently. An area of particular interest appears to be longevity risk transfer, said Brookes, as companies look to find ways of coping with risks associated with increased life expectancy. The threat is particularly acute for pension companies concerned with funding future liabilities, with the need helping to create a “nascent longevity risk market”. Interest is such that RMS has invested in a “major research initiative to produce the world’s first structural model of longevity risk”, as firms struggle to get a handle on rising exposures.
Brookes explained that the longevity risk transfer market has the “potential to dwarf the catastrophe risk transfer market”. If the population lives five years longer than expected, it will increase annual liabilities for the pension industry by 10 percent, adding $1 trillion in costs, he said. Much of this could—and may need to—be securitised, presenting considerable opportunities for the capital markets. Such transactions would need to be supported by robust models and quantifiable data, said Brookes, adding that companies such as RMS have the capabilities to bring such diversifying perils to the capital markets.