Insurance-Linked Securities: Taking the market by storm
Insurance-linked securities are gaining popularity as a diversifying asset class, but what are the available strategies, underlying risks and costs? Carlo Svaluto Moreolo finds out
At a glance
• The ILS marketplace is growing, with traditional asset managers launching ILS strategies and funds.
• A variety of liquid and illiquid strategies is available to investors.
• The asset class is generally decorrelated from the wider markets but the risk can vary greatly between strategies.
• Fees also vary, from active fixed-income levels to more costly hedge fund-like levels.
While the main priority for institutional investors in 2014 was finding yield, last year the focus turned to preserving capital. One asset class that promises to deliver both income and decorrelation from the wider financial markets is insurance-linked securities (ILS).
In a nutshell, ILS are a way for insurers and reinsurers to pass on unwanted risk to the capital markets. Investors in the asset class will effectively underwrite the same risks that insurers and reinsurers do, collecting premiums and paying out losses as and when they materialise.
The direct transfer of reinsurance risk to the capital markets began in the wake of the devastating hurricane Andrew, one of the costliest hurricanes in US history. The storm struck the south-eastern US coastline in 1992, wreaking about $26.5bn worth of damage.
In the aftermath of the storm, reinsurers were looking for additional capacity to take on catastrophe risk. Premiums being paid by insurers for catastrophe risk reinsurance were high, as naturally occurs after a large catastrophe.
But the demand for reinsurance outstripped the capacity of reinsurers’ balance sheets. This prompted them to look for new sources of underwriting capacity in the capital markets.
The first catastrophe bonds were launched in the mid-1990s. Since then, the market for ILS has come a long way. According to Willis Towers Watson, non-life ILS capital reached $70bn (€64bn) at the end of 2015, having grown by almost 8% from $65bn at the end of 2014.
For a niche asset class, ILS provides a great variety of securities, deal structures, strategies and even risks. By definition, investors in ILS will source returns in insurance risk. As such they can choose between many risks, from earthquake risk to hurricane risk in different parts of the world (see Explaining the insurance-linked securities market).
Initially, insurance and reinsurance risk-transfer to the capital markets focused on non-life risks, such as catastrophe risk. As the appetite from the capital markets has grown, the insurance community has also seen an opportunity to transfer non-life risk.
Today investors can choose between underwriting non-life risks and life risks. The latter comprises, for instance, mortality risk, or the risk that holders of life insurance die earlier than forecast. The life risk ILS market largely consists of private transactions.
In the beginning, investors in ILS were mainly hedge funds. They could withstand the relative illiquidity of the assets and allocate research and origination capacity specifically to the asset class. But pension funds have increased their participation in the market.
Among the first to invest were large Nordic and Dutch pension funds, notably the Swedish buffer fund AP3 and Dutch giant PGGM (see case studies in this section). Smaller pension funds, especially in Switzerland, entered the market later.
Asset managers get in on the game
Several specialised asset managers and a handful of large ones with strong links with the insurance community have traditionally dominated the provider side. Firms such as Leadenhall, LGT Capital Partners, Securis, and Twelve Capital belong to the first category. AXA Investment Management and Credit Suisse belong to the second.
But, of late, traditional managers are trying to establish themselves in the market. Several well-known managers have launched ILS strategies or funds, as they see attractive growth potential in the market.
Last August, Lombard Odier Investment Managers hired Gregor Gawron and his team from Zurich-based investment managers Dynapartners. Gawron was tasked with creating an ILS product range for LOIM.
Deutsche Asset & Wealth Management (DeAWM) has worked on the launch of an ILS fund since the beginning of 2013, and it was reported to have finally launched the fund at the beginning of last year.
As volatility in the financial markets increases, ILS can provide some relief to institutional portfolios. There is no demonstrable correlation between hurricanes in the US east coast or Japanese earthquakes and the equity or bond markets.
Swiss Re launched a cat bond index in 2007, tracking the performance of cat bonds since 2002. As LOIM’s Gawron points out, the annualised performance for the index has been 8.2%, with a volatility of less than 3%. This includes several large loss events, from hurricane Kathrina in 2005 to the Japanese Tōhoku earthquake and tsunami of 2011.
According to Bloomberg, since launch, the correlation between the Swiss Re index and major indices ranges from 0.30, which is the case for the HFRX Global Hedge Fund index, and 0.17 for the S&P500.
Collateralised reinsurance and insurance loss warranties (ILW) may also be palatable to institutional investors, depending on their willingness to immobilise a part of the portfolio within a relatively illiquid market.
Questions for investors
The most important question for investors is the source of risk and return. The answer seems obvious. In insurance, investors agree to provide their counterparties with protection from financial loss in exchange for a premium. The risk is the probability that the financial loss arises, while the return is the premiums collected minus the claims paid. This is, in essence, the business model of an insurer.
However, the extent to which one should and could diversify across different risks within an ILS portfolio is far less obvious. Investors will need to be sure that their portfolio is not too concentrated on any single risk. It would be foolish to focus on one catastrophe risk in one region, as a single event could wipe out the entire investment. At the same time, because this is a low-capacity asset class, building a well-diversified portfolio is difficult and takes time.
Bob Swarup, principal at Camdor Global Advisors sees the limited availability of data as the biggest challenge for the sector. He says: “Pension funds invest in this asset class because they want to diversify. Diversifying your risk is good, but you still want to understand each of them individually. And the lack of data makes these risks difficult to understand, which, in turn, makes it hard to model and price ILS.”
Furthermore, it is key for investors to understand how loss events will affect the investments. In cat bonds, sponsors can establish triggers at which the coupon and principal are progressively affected if the event occurs and depending on its severity. In private transactions, the impact of loss events is also established ex ante.
But in both cases, because of the complexity of the structures, it might not be easy to grasp the overall impact of loss events on portfolios.
Andrew Tromans and Nick Bugler, partners at Willkie Farr & Gallagher, a law firm that advises investors and insurers on ILS, explain that within ILS structures there can be a tension between the short-term objectives of investors and long-term objectives of insurance companies.
They say: “The investors’ priority will be getting their return realised as soon as possible. On the other hand, the ILS sponsoring entity wants reinsurance that it knows will respond to the claims it makes. The issue it will face is that claims can take a long time to develop.” In other words, the final quantity of the claims can remain unknown for some time after the loss event.
Also, it would be wrong to assume that cat bonds and other ILS transactions carry no credit risk. It takes a lesser role than in traditional fixed-income investments, but it should, nevertheless, be understood how it might affect investments.
Tromans and Bugler note that collateralisation is an issue that investors and insurers are increasingly concerned with, partly owing to heightened regulatory standards. “There can be loss of value because of the way the reinsurance vehicle is structured with respect to collateral. Investors will want to feel very comfortable with the collateral arrangements.” In cat bonds, they add, that may be even more important than the rating of the instrument itself.
This is where skilled, experienced managers will help, by building diversified portfolios and explaining the impact of loss events and other underlying risks clearly to investors.
Another relevant aspect to consider is the relationship between the risk/return profile and maturity of ILS instruments. This differs completely from traditional asset classes. Just consider that one or several significant loss events affecting the whole industry can take place in any single year. But many years can go by without any major losses materialising. Yet, for obvious reasons, ILS have a short time horizon.
That begs the question: how much time should investors have commit before reaping attractive returns from this asset class? The answer is not clear. Liquidity profiles offered by ILS managers vary greatly, depending on the strategy. They can range from weekly redemptions for the most liquid strategies focusing only on cat bonds, to annual redemptions for the most illiquid strategies.
Is there a question of timing when investing in ILS? Cat bond issuance started to decline last year, after continued year-on-year growth since 2011. The total issuance in 2015 was $62.bn (€5.6bn), down 22.5% from 2014. This is clearly driven by declining reinsurance rates.
The absence of significant loss events in the past few years is pushing down reinsurance premiums, making it cheaper for insurers to access reinsurance capital than the financial markets. But the picture can change at any time if mother nature decides to strike – therefore, timing should perhaps be less of a concern.
Furthermore, as LOIM’s Gawron puts it: “In this market, sellers will always find natural buyers within the reinsurance industry. Reinsurance moves on different business cycles. We see ILS as the only ‘free lunch’ in financial markets.”
Logically, a well-diversified portfolio is more likely to stand the test of time, but the expected return will be much higher for portfolios focusing on higher-yielding private transactions. Clearly, however, investors with a long-term horizon should focus on both the liquid and the illiquid parts of the market.
Second, should the asset class sit in a portfolio’s fixed-income or alternative bucket?
Because cat bonds are essentially coupon-paying securities, some will see it as a fitting instrument in a diversified fixed-income portfolio. Similarly, private transactions are marketed as ‘cash-plus’ products. But the asymmetric risk profile makes the asset class more suitable for the alternative bucket.
Alasdair Macdonald, UK head of advisory portfolio management at Willis Towers Watson, says: “We wouldn’t see ILS as part of the fixed-income universe. They have some characteristics of fixed income, and some fixed-income managers invest in cat bonds, but the biggest part of the ILS market is not cat bonds. The larger part of the market concerns private transactions. As a wider asset class it’s an alternative asset class, and it’s as a diversifying strategy. It’s just about the only one we think should have no correlation with other asset classes.”
“We see ILS as the only ‘free lunch’ in financial markets”
Third, what should the target allocation be? The question is relevant because estimating the risk-adjusted return from an ILS portfolio is a completely different affair from estimating returns from a portfolio of other securities. This means that a traditional optimisation exercise cannot be extended to ILS.
As a rule of thumb, consultants are advising single-digit allocations in percentage terms. Daniel Peters, a partner in the global consulting team of Aon Hewitt, says that, as a pure diversification investment, the allocation has to be “big enough to justify time and efforts of trustees”. A 5% to 10% allocation, he argues, would be suitable, depending on the pension scheme.
Macdonald adds: “Because it has basically no correlation with equity markets, you could justify quite a large allocation on diversification grounds. But it has significant left tails. It exists because someone else wants to hedge that left-tail risk. Therefore, investors should scale it appropriately with a large loss in mind, and diversify sensibly across insurance risk.”
Furthermore, Macdonald cautions that because many ILS products target a ‘cash-plus’ return, investors should also scale the allocation depending on expectations for cash returns. And even the spreads, he notes, have come down significantly over the past year.
Finally, what should investors be prepared to pay for these strategies? The fee levels vary somewhat, from fixed income-like fees to arrangements similar to hedge funds.
Consultants agree that this is a relatively expensive asset class, while there is some disagreement on whether performance fees charged by some managers are appropriate. Macdonald argues: “We really struggle with the concept of paying a performance fee in this asset class. We think the fees should be flat and be closer to the fixed-income end of things.”
Peters says: “Fees are relatively high compared with where expected returns are now. But the choice between flat fees and performance fees should be based on investors’ preference. It is worth paying a manager to put a solid portfolio together for you, especially in the risky part of the market.”
For insurers, the ILS market has become an efficient way to reinsure large chunks of risk. Solvency II, the new European insurance regulatory framework effective from this year, also encourages insurers to access the capital markets.
However, the growth of the ILS market is constrained by several factors. One is the relatively small numbers of managers in the sector. The cyclical nature of the market, whereby at times insurers will find it cheaper to use reinsurance capital, also constrains growth.
On the demand side, one of the is the limited total size of the market. For large pension funds, it may be difficult to allocate even a relatively small percentage of the portfolio. Conversely, small pension funds face the usual constraints of investing in a relatively obscure asset class – illiquidity and complexity.
An imbalance between demand and supply of ILS, according to Swarup, can be dangerous. It exacerbates the impact of information asymmetries between managers and investors and, as a result, increases the potential for mispricing risk.
Pius Fritschi, managing partner at LGT Capital Partners, expects growth in the market to continue, but he is cautious about the entrance of non-specialised managers. He says: “Most of the new entrants don’t have the insurance capability and expertise, so they tend to enter into the cat bond markets when the spreads are not that attractive anymore. They may lack the underwriting knowledge that is needed for these markets in the liquid and illiquid part.”
But in pension funds’ portfolios, an allocation to ILS can serve as a source of decorrelated income and diversification. This is why investors should expect steady, but gradual, growth in ILS over the coming years, perhaps regardless of what happens in the wider financial markets.
But the performance of individual portfolios will depend on the finite set of underlying risks, so no portfolio will be always immune from large loss events. As Macdonald puts it: “The old cliché that past performance doesn’t tell you about future performance is particularly true in this market.”
Explaining the insurance-linked securities market
• Catastrophe bonds represent the most liquid, and perhaps most easily approachable part of the ILS market. They are floating-rate, short-term instruments, usually with a maturity of three to five years. The issuer, either an insurer or a reinsurer, pays coupons so long as the catastrophe event that it provides insurance against does not materialise.
• According to Artemis, a provider of data on ILS, at the end of 2015 the outstanding cat bond capital was just shy of $26bn (€23.7bn). Many of the coupons (about 40%) ranged from 2% to 4%, while securities paying coupons of 4%-6% and 6%-8% were both about 21% of all coupons paid. About 13% of coupons ranged between 8% and 12%.
• Cat bonds are deemed to be liquid because daily valuations are available and there is a secondary market of sorts. But even before the birth of the cat bond market, the insurance community had found other ways to offload risks to the capital markets. Institutional investors were willing to underwrite a variety of risks in ‘private’ transactions, which closely resembled actual insurance and reinsurance contracts.
• In cat bond transactions, investors behave like traditional fixed income investors. In private transactions, the ‘illiquid’ part of the market, they act more like insurers or reinsurers. Private transactions vary greatly in terms of structure and underlying risks. However, they can be roughly split between ‘collateralised reinsurance’ and ‘industry loss warranties’ (ILW).
• Collateralised reinsurance, as the name suggests, consists of fully collateralised transactions. Institutional investors will underwrite risks by reserving collateral that fully matches the total potential loss, and receive premiums in exchange. But the amount paid out by investors in case of an will be equivalent to the actual damage incurred by the insured.
• In ILW transactions, instead, the terms of the contract will set the actual amount paid out by investors if the event takes place. But the payment of the sum will be triggered only if the loss incurred by the whole industry exceeds a set amount.
• Private transactions usually have a 12-month time horizon, which is accepted as the minimum period for significant losses to materialise across the globe.