Who’s afraid of life risk?
Investors in insurance-linked securities (ILS) generally underwrite non-life risk, but sometimes insurers are willing to offload life risk as well, finds Carlo Svaluto Moreolo. What can investors expect from entering the life-risk market?
At a glance
• The life insurance-linked securities (ILS) market has lagged behind non-life ILS.
• Most managers with life capabilities offer combined life and non-life strategies.
• Insurers are increasingly willing to transfer both mortality and longevity risk.
• Structures and fees are similar to non-life risk transactions.
Common sense tells us that when investing in insurance-linked securities (ILS), one should favour diversified strategies. It is not wise for investors to put all their money on one risk and one region – say, earthquakes in Japan. In that situation a massive event can wipe out the portfolio completely.
That is why investors look for ILS strategies that involve a variety of risks, regional exposures and types of transactions. However, since the beginnings of the ILS market, insurers have generally focused on transferring non-life risks.
But for pension funds seeking exposure to the ILS market, the ultimate diversification frontier could be between non-life and life ILS. According to Dan Knipe, senior portfolio manager at Leadenhall, a London-based ILS asset manager with $2.6bn (€2.3bn) of assets under management, the life risk transfer business is a longer-term investment and provides investors with more stable cashflows compared with non-life.
He says: “Risks tend to be very remote, and as investors look for diversifiers they should look at this market. The potential to earn a better risk-adjusted reward is already there because, at the moment, there is less competition than in the non-life market.”
But investing in life risk is, arguably, more complex than investing in non-life risk. This is not necessarily the result of the complexity of risks and structures, but rather to the scarcity of managers who engage in ILS. Furthermore, most life-risk transactions are over-the-counter. They belong to the ‘private’ and ‘illiquid’ part of the ILS market and, as such, there is relatively little transparency regarding their size and structure.
Life risk will include both mortality and longevity. The first is the risk that holders of life insurance policies die earlier than expected, while the second is the risk that beneficiaries of annuities live longer than expected.
Longevity risk is a well-known threat in the pension industry. Insurers are also largely exposed, and are active on both sides of the market, being both buyers and sellers of longevity risk hedging.
For pension funds, longevity will not be the right type of risk as they carry exactly that risk themselves. Mortality risk, including the risk of extreme mortality, may be more suitable for pension funds’ portfolios.
Similarly to the non-life ILS sector, these transactions can take various forms and invest in various sources risks. They can consist of swap arrangements, collateralised loans, structured notes, bonds or even plain reinsurance, when asset managers ‘borrow’ portions of reinsurers’ balance sheets. Often transactions will involve special purpose vehicles (SPVs), set up especially to insure mortality or longevity risk, in exchange for premiums.
However, whatever arrangement is in place, the main goal in life transactions is to achieve partial collateralisation, notes Andrea Cavalleri, head of life origination at Securis Investment Partners, a London-based ILS manager with offices in Bermuda and Geneva. It manages more than $3.5bn in ILS strategies and has been particularly active in life-risk transactions.
Cavalleri says asset managers like Securis have a competitive advantage when approaching the life insurance market. He says: “We present ourselves to the insurance market as an attractive alternative to reinsurance. We underwrite life risk in the same way a reinsurer would do, but from an asset management platform. The advantages are that we are not subject to the same regulation as insurers and have a leaner structure.”
In life-risk transfer, the way losses are determined differs somewhat from the non-life context. Although large loss of life can be caused by individual events, in most cases life risk is not realised in a short period of time.
Two common types of transactions, distinguished on the basis of how losses are accounted for, are indemnity-date transactions and parametric insurance.
In the first case, the risk is calculated on a specific bundle of policies. If there is a swap agreement in place, it will be linked to the performance of that specific bundle of policies, for instance the actual mortality rate of that bundle.
In these transactions, explains Cavalleri, it is important to minimise the concentration risk of policies. In other words, it is best to ascertain that there is minimal potential correlation between the individual risks carried by individual policyholders.
Parametric insurance follows similar rules in life and non-life insurance. Losses are determined by triggers, or parameters, that are usually based on the behaviour of the general population. “These transactions are somewhat simpler, in that they do not require the insurer to share a large amount of data on the risks it is reinsuring. There is, however, the risk that the behaviour of the insurers’ policies does not follow that of the general population,” says Cavalleri.
Securis offers segregated accounts and funds combining non-life and life risk. The firm offers different liquidity profiles according to the expected risk/return. Because of the lack of a daily net asset value (NAV), some of the funds are not compliant with UCITS. However, Cavalleri points out that the firm offers monthly NAV.
For the most illiquid strategies, with a high portion of private transactions, Securis’ funds offer redemptions with six months’ notice after a one-year lock-up period. “But even at the peak of the crisis, we were always able to withstand redemption requests form our clients. This is the proof that we can construct balanced portfolios”, adds Cavalleri.
Fees can vary from a low flat management fee for the UCITS funds, to hedge fund-like structures. The Securis 1 fund, which is the most complex one and posted an annual average net return of 9.6% since 2005, levies a 2% management fee and 20% performance fee.
The fund and fee structures resemble the non-life ILS sector. So why has diversification in ILS portfolios given little space to the life risks?
Knipe says this has to do with how securitisation was conducted before the crisis. “Most of the transactions were structured and guaranteed by monoline wrappers, which relied on commercial paper conduits. There was no need for asset managers to understand the underlying structures and the risks,” he explains.
The growth of the overall ILS market suggests the life-risk transfers to the capital markets are growing in number and size. Yet it is difficult to get an exact idea of the current size of the life-risk transfer market.
In 1998, Hannover Re was the first reinsurer to sign a life transaction with capital market investors to transfer acquisition costs from life reinsurance business. The German company signed several life ILS transactions between then and 2009, all of which have since come to an end. For a long period after that, the company did not engage in further life ILS transactions. It has been active in the non-life side, having a dedicated ILS department.
Henning Ludolphs, managing director for retrocessions and capital markets at Hannover Re, says that after 2009 the company had no further need to find liquidity in capital markets for life transaction. However, Hannover Re has placed extreme mortality risk with ILS investors since 2013, and is currently working on several life ILS transactions.
Ludolphs says the life ILS market will grow, as demand from investors and supply from insurers come together. He argues: “Life transactions take much longer to assess. They are long-term transactions, and there are different questions from the non-life side. Investors took some time to understand the catastrophe bond business, but eventually it took off and really started to grow. As we begin seeing more life ILS transactions, investors will assess those and see their attractiveness. I am optimistic that we will be among the companies that benefit from that.”
Knipe says Solvency II will also be a huge driver for growth of life-risk transfers, as it should push all insurers towards the capital markets.