Diversifying into aviation, marine and energy risks through private placements makes sense from a risk-and-return perspective, writes Anthony Harrington 

At a glance 

• The private market in ILS is double the public market and is exposed to more perils.
• OTC commitments are generally longer than in the public market.
• The lack of liquidity should result in higher returns. 

The most usual route for pension funds to get into the insurance-linked securities (ILS) market is through publicly placed catastrophe bonds or via funds specialising in those bonds. There are two reasons for this. First, the yields on catastrophe bonds, particularly on US wind, are higher than for other perils. 

Second, publicly placed cat bonds are well documented, reasonably transparent, and relatively easy for pension funds to understand. 

However, while the catastrophe bond market is about $23bn (€20.7bn), the total ILS market, which includes sidecars and private placements, is about $70bn. Moreover, not only is the total ILS market larger than the cat bond market, it also contains far more perils, including specialty lines like aviation, marine, energy and agriculture, as well as privately placed cat bonds. This makes it far easier for a fund manager to construct fully-diversified portfolios for pension fund investors when the investor is open to the idea of participating in private placements. 

However, as Daniel Ineichen, head of ILS at Schroders explains, it can be a complicated process for pension funds to get into the private-placement market. By definition, there is no detailed, generally available prospectus for a private placement. The broker or brokers acting for the insurance or reinsurance company or other entity doing the placement will have a select set of potential investors that are already well known to the broker and who will be offered the opportunity to participate.

“There is no doubt that when you access private transactions, you have a wider field from which to construct your portfolio. But for a pension fund, starting from scratch to become well-known to the placing brokers is very difficult. Instead of going direct, you would want to give a mandate to a third-party fund manager who already has strong relationships with distributing brokers,” he says.

Whatever the peril you are taking on with a particular placement, whether it is one of the specialty lines, a private cat bond or mortality, there will be very clear definitions of what constitutes the trigger for the bond. Tim van Duren, investment director, ILS, at Schroders says: “Many triggers are based on the excess loss concept, where the insurance company will bear the first losses on the peril up to a stated maximum, and if losses exceed this, the bond will trigger.”

The private market grew more than the public cat bond market through 2015, Ineichen and Van Duren point out, largely because the risk/reward ratio was better. This generally involves measuring the expected loss percentage, which is usually calculated by a third-party risk-modelling agency, against the yield.

“There is no doubt that when you access private transactions, you have a wider field from which to construct your portfolio”
Daniel Ineichen

“Transactions on the private side can often be multi-peril contracts, where a single contract will cover either several regions or several perils. Investors need to take a sophisticated approach here, analysing the composition and construction of their portfolio carefully to avoid unlooked for concentrations in specific perils or geographies,” Duren says. The cat bond market has an independent claims verifier for each bond but this is not the case in the private market, so you really need to understand what you are committing to. 

Sandro Kriesch, managing partner and head of private ILS at Twelve Capital, argues that while the larger portion of the ILS market is almost exclusively focused on US property risks in one form or another, the speciality ILS lines include a far richer array of perils and regions. However, the caveat here is that you need a fund manager with specific expertise and capabilities in these areas.

“With private placement it is usually possible to move further up the vertical [return] axis while levels of risk on the horizontal axis remain broadly unchanged – that is quite a differentiating factor for this sector”
Sandro Kriesch

“Take marine peril as an example,” he says. “Marine is often looked at as a pure transport market, be it for goods or passengers. At Twelve Capital, though, transport or the long-haul container market are not of particular interest. What are of interest for the firm are offshore oil and gas platforms and pipelines. These classes belong to the marine class but, crucially, they are referred to as short-tailed risks,” he says. 

ILS in all its forms, public or private, is not generally suited to long-tailed risk. Investors do not want to see their money tied up for longer periods while the various parties are potentially locked in litigation for years. 

Investors generally commit capital for one year in the private placement market, whereas most catastrophe bonds typically have a duration of 3-5 years. The shorter time frame in the private-placement market compensates for the fact that there is no secondary market in these private ILS transactions. It is buy-and-hold to maturity, whatever the peril that forms the basis of the placement. 

An example of a long-tailed risk would be personal injury or liability insurance. “The market has seen asbestos cases, for example, taking 20 years and more to pass through the courts – that kind of risk is not generally compatible with the ILS space,” Kriesch says. Duration risk in marine and transport peril in aviation could be shortened by offering hull-only protection, he notes. This would pay for the loss of the vessel or aircraft respectively. 

A really crucial point that potential investors need to grasp with private placements, Kriesch points out, is that the illiquidity premium associated with these opportunities means that you can potentially achieve an increase in yield, often without a corresponding increase in insurance risk. 

“If you look at a classic Markowitz chart of risk versus return, with private placement it is usually possible to move further up the vertical [return] axis while levels of risk on the horizontal axis remain broadly unchanged – that is quite a differentiating factor for this sector,” he says. 

Francois Divet, head of ILS at AXA IM puts matters simply. “If you are looking for 5% or better risk-adjusted returns, rather than 3-5%, then you have to look at the private placement market,” he says. The costs to a cedant of issuing a private ILS placement are considerably lower than for a cat bond. This makes it possible for private placements to be in the $1m-10m range, instead of the $150m-200m one sees in the cat bond sector. 

“It is important to remember that all the risk for evaluating the bond is on the buyer in the private-placement market, whatever the perils being offered. So you need to have the capability to do your own modelling or to have a third-party fund manager that you can rely on,” Divet warns. 

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