Returns on insurance-linked instruments such as catastrophe bonds have risen in recent months, making them an increasingly attractive asset class, writes bfinance Australia’s Frithjof van Zyp.
However, there are a number of pitfalls that investors should be aware of before they deploy their capital, including the increasing potential for conflicts of interest in some segments of the market.
Insurance-linked securities (ILS) are a means through which investors can participate in the profits, and losses, of underwriting the risks of major insurable events, such as earthquakes and cyclones.
Developed in the mid-1990s in the aftermath of Hurricane Andrew and its massive impact on Florida, ILS are issued by insurance companies and reinsurers – the insurers of insurers – who want to limit their exposure to disaster risk and transfer some of it to external investors.
Hurricane Andrew was the costliest hurricane to make landfall in the US until it was surpassed by Hurricane Katrina in 2005.
It ushered in the bankruptcy of nine insurers and led to the creation of innovative new financial architecture designed to draw new and more diverse sources of the capital to the insurance industry.
The ILS market has attracted an influx of capital from investors seeking diversification – given ILS returns are largely uncorrelated to macroeconomic variables – and attractive yields, especially important in the low-rate interest rate era of the last decade, and has grown to be around US$100 billion in size, according to our estimates at bfinance.
The two most popular forms are catastrophe bonds, also known as CAT bonds, and private forms such as collateralised reinsurance.
Until recently, strong demand from investors was compressing yields, and returns from the asset class were in a long-term decline until a spate of natural catastrophes in 2017, including hurricanes Harvey, Irma and Maria in the US, the Mexican earthquake and the Californian bushfires.
The decade-long downward trajectory of investor returns was interrupted by the December renewal season, which saw premiums jump around 10–20 per cent from the previous year.
As investors watch closely to see if current premium levels will be sustained, bfinance’s recently conducted research into the universe of ILS managers has detected three main pitfalls that investors must navigate if they are to successfully invest in the market.
Conflicts of interest
Increasingly over the last decade, reinsurance and insurance companies have embedded ILS investment units within their own firms or taken stakes in third party managers.
Recent examples include AIG’s acquisition of reinsurance firm Validus (of which ILS manager AlphaCat is a subsidiary), and AXA’s purchase of XL Group (which holds a stake in ILS manager New Ocean Capital).
The ILS managers involved can point to benefits that come from their insurer/reinsurer parentage. It provides access to expertise and systems that help to model risks, price contracts and even source deals.
Yet investors must vigorously scrutinise how conflicts of interest are being managed.
At one end of the spectrum, we find insurance/reinsurance firms effectively using institutional capital to grow their business.
The sale of a contract by a reinsurer improves that reinsurer’s weighted average cost of capital (WACC); raising more capital means that they can insure more risk.
Yet there is a potential conflict, wherein the ILS manager could be encouraged to underwrite risks for the parent in a manner that may not be in the best interests of third party investors.
At the opposite side of the spectrum, we find examples of strict separation: one very large French reinsurer, for instance, has an ILS investment arm that is now completely prohibited from investing in any contracts from their parent.
A manager’s ownership should not necessarily count against them.
Yet strong processes to separate the activities of the manager from the interests of the parent are very important, as are track records demonstrating the resilience of those processes through challenging periods.
Non-performing contracts and ‘side pocAhkets’
The term ‘side pocket’ might bring back unpleasant memories of hedge funds in 2008.
During the global financial crisis, up to a third of hedge fund managers put their more illiquid investments into separate sleeves to limit redemptions and, in some cases, artificially inflate management fees.
The side pockets in the ILS sector are more benign, but investors should scrutinise their use with care. They exist, in essence, because of the impossibility of pricing some private ILS with complete accuracy.
Managers assess expected losses after disasters, based on estimates drawn from large insurers.
Yet the actual pay-outs owed by the manager to the originator of the contracts may not be clear for up to two years, even though the duration on those securities tends to be one year at most.
Side pockets are designed to ensure that the manager can cover those liabilities and prevent new investors from being exposed to assets that do not pay a premium.
They are generally created before large inflows of new investor money.
In recent manager research, we have found funds where up to 40 per cent of assets were in such sleeves.
These are, in essence, non-performing assets for as long as the side pocket is maintained.
As such, they act as a drag on overall returns for past investors in the fund, until and unless the side pocket is successfully liquidated, which is itself uncertain.
During manager selection, investors should take care to ensure that non-performing assets have been side-pocketed to that they don’t act as a drag on their future returns.
In addition, it is important to check that managers disclosing past performance have included the side pocket in their return figures and done so in an appropriate way.
Larger investors and managers seeking to deploy a significant volume of capital face distinctive challenges.
The CAT bond market, while liquid, is shallow in comparison to sectors such as high-yield debt with a volume of approximately US$25 billion.
An individual asset manager with US$4–5 billion in catastrophe bonds will effectively hold nearly 20 per cent of the market.
This leaves the market vulnerable to pricing hikes as a result of inflows, posing a problem for large funds and investors seeking to make substantial allocations. The median fund size in the private ILS sector is around US$1 billion.
For asset managers that want to grow rather than cap their funds, there is only one way up the ladder: rated reinsurance.
This is a far bigger market, but investment managers that make the transition – effectively becoming reinsurers in their own right – are no longer a big fish in a small pond.
Instead they become small fish in a very large pond, competing against the likes of Swiss Re and Munich Re.
bfinance expects continuing investor demand for ILS due to the compelling diversification benefits offered by this market.
Yet asset owners seeking CAT bonds and private ILS transactions should handle implementation with care.
Manager selection and choice of sub-sector are critical to successful investing in this asset class.
Frithjof van Zyp is director of bfinance Australia.
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