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Exploring the evolution of the insurance-linked securities market (ILS) and examining the role of specific instruments in an investor’s portfolio.

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MEDIA PARTNERS

MAY 2014

INSURANCE-LINKED SECURITIES FOR INSTITUTIONAL INVESTORS 2014

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Michael R. Halsband

President, Sirius Capital Markets

Commissioner John D.

Doak

Oklahoma Insurance Department

Andrew Mawdsley

Head of Financial Stability and Information Unit, European Insurance and Occupational Pensions Authority (EIOPA)

Aashh K. Parekh

Managing Director, Global Public Market, TIAA-CREF

Dirk Lohmann

Chairman & Managing Partner, Secquaero Advisors

Dan Bergman

Head of Investment Research & Insurance-Linked Securities, AP3

FOREWORD 7

Insurance-linked securities at a crossroads

Michael R. Halsband, President, Sirius Capital Markets

SPECIAL GUEST ADDRESS 9

The importance of capital markets to the insurance sector in a post-disaster period

Commissioner John D. Doak, Oklahoma Insurance Department

SECTION 1EVOLVING TRENDS FOR MAXIMUM RETURN STREAMS

1.1 INTERVIEW 11

Has capital influx saturated the insurance-linked securities market and what should investors’ response be?

Interviewer: Jessica McGhie, Senior Publisher, Clear Path AnalysisInterviewee: Andrew Mawdsley, Head of Financial Stability and Information Unit, European Insurance and Occupational Pensions Authority

1.2 ROUNDTABLE 13

What is the future for insurance-linked securities and is broader participation in new reinsurance areas appetising?

Moderator: Steve Evans, Owner and Editor, Artemis.bmPanel: Aashh K. Parekh, Managing Director, Global Public Market, TIAA- CREF Dan Bergman, Head of Investment Research & Insurance-Linked Securities, AP3 Isaac Anthony, Chief Executive Officer, Caribbean Catastrophe Risk Insurance Facility (CCRIF) Dirk Lohmann, Chairman & Managing Partner, Secquaero Advisors

1.3 WHITE PAPER 17

Insurance-linked securities capital: reinsurance industry threat or saviour?

Dr. Urs Ramseier, Partner, Chairman of the Board of Directors and Chief Investment Officer, Twelve CapitalJohn Butler, Partner, Head of Sourcing and Underwriting, Twelve Capital

SECTION 2THE CATASTROPHE BOND EVOLUTION

2.1 WHITEPAPER 21

Above and beyond: why insurance-linked securities have to evolve beyond catastrophe risk

Dirk Lohmann, Chairman & Managing Partner, Secquaero Advisors

2.2 INTERVIEW 25

The catastrophe bond market is not the whole market

Interviewer: Sarah Mortimer, Account Director, rein4ceInterviewee: Adam Beatty, Business Development Director, Nephila Advisors

CONTENTS


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INSURANCE LINKED SECURITIES FOR INSTITUTIONAL INVESTORS 2014

Dr. Urs Ramseier

Partner, Chairman of the Board of Directors and Chief Investment Officer, Twelve Capital

Adam Beatty

Business Development Director, Nephila Advisors

Michael Stahel

Partner, LGT Insurance-Linked Strategies, LGT Capital Partners

Niklaus Hilti

Head of Insurance-Linked Securities Strategies, Credit Suisse Asset Management

Fiona Le Poidevin

Chief Executive, Guernsey Finance

Tony Rettino

Founding Principal and Portfolio Manager, Elementum Advisors

2.3 INTERVIEW 27

Diversified vs. concentrated portfolios: exploring a catastrophe bond and collateralised securities blend

Interviewer: Sarah Mortimer, Account Director, rein4ceInterviewee: Michael Stahel, Partner, LGT Insurance-Linked Strategies, LGT Capital Partners

SECTION 3THE EMERGENCE OF LIFE RISK

WHITE PAPER 31

Packing life risk into capital markets for maximum indemnity coverage

Marcel Grandi, Head of Life, Credit Suisse Asset Management

SECTION 4PICKING YOUR DOMICILE

WHITE PAPER 35

Experience and expertise: a key ingredient for ILS domiciles

Fiona Le Poidevin, Chief Executive, Guernsey Finance

SECTION 5THE LONG-TERM HORIZON

5.1 INTERVIEW 40

Building a sustainable reinsurance model

Interviewer: Steve Evans, Owner and Editor, Artemis.bmInterviewee: Tony Rettino, Founding Principal and Portfolio Manager, Elementum Advisors

5.2 ROUNDTABLE 43

What are the challenges of evolving insurance-linked securities structures?

Moderator: Steve Evans, Owner and Editor, Artemis.bm Panel: John Whiley, Head of ILS Administration, SS&C GlobeOp Daniel Ineichen, ILS Portfolio Manager, Schroder Investment Management Stephen Rooney, Partner, Mayer Brown

5.3 INTERVIEW 48

Advantages of working with an insurance-linked securities manager within a reinsurer

Interviewer: Jessica McGhie, Senior Publisher, Clear Path AnalysisInterviewee: Vincent Prabis, Head of ILS Strategies, SCOR Global Investments

CONTENTS


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CONTENTS


John Whiley

Head of ILS Administration, SS&C GlobeOp

Vincent Prabis

Head of ILS Strategies, SCOR Global Investments

Elizabeth Garner

Head of Pensions and Investment, Save the Children

SECTION 6INTERPRETING AND QUALIFYING RISKS

6.1 INTERVIEW 52

Comparing risk-adjusted returns in insurance-linked strategies

Interviewer: Jessica McGhie, Senior Publisher, Clear Path AnalysisInterviewee: Niklaus Hilti, Head of Insurance-Linked Securities Strategies, Credit Suisse Asset Management

6.2 ROUNDTABLE 54

Achieving optimum diversification: understanding liquidity, volatility and performance risks for uncorrelated yield

Moderator: Steve Evans, Owner and Editor, Artemis.bm Panel: Elizabeth Garner, Head of Pensions and Investment, Save the Children Jens Hagendorff, Professor of Finance, The University of Edinburgh Adam Beatty, Business Development Director, Nephila Advisors

6.3 INTERVIEW 59

The impact of risk spreads on insurance-linked securities instruments and their suitability

Interviewer: Steve Evans, Owner and Editor, Artemis.bmInterviewee: Dr. Erwann O. Michel-Kerjan, Managing Director, Risk Management and Decision Processes Center, The Wharton School, University of Pennslyvania

Libby Britcher

Marketing & Operations Manager

Jim Allen

Senior Digital ProducerNoel Hillmann

Managing Director & Head of Publishing

Jessica McGhie

Senior Publishing & Strategy Manager

Jennifer Menoscal

Marketing Assistant

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ABOUT CLEAR PATH ANALYSIS

Clear Path Analysis is a media company that specialises in the publishing of high quality, online reports in the financial services and investments sector.

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SPONSORS

Credit Suisse is one of the world’s leading financial services providers with presence in over 50 countries. The Insurance Linked Strategies team is embedded within the

Asset Management business and is one of the largest managers in ILS with $6bn AUM and a track record of more than 11 years.

Elementum Advisors, LLC is an independent alternative investment manager specializing in collateralized natural event reinsurance investments. The Elementum

team possesses a lengthy track record of alpha generation and experience managing portfolios across a range of objectives - from liquid catastrophe bond to high alpha direct reinsurance strategies.

amfunds.credit-suisse.com

www.elementumadvisors.com

G uernsey’s long track record and existing expertise gained in the investment funds and insurance sectors are optimised and combined in its ILS offering – fund managers and

promoters with capital to deploy are brought together with transformation managers who understand insurance risk. The Island also offers innovative structures and access to a variety of global capital markets.

LGT Capital Partners is a leading alternative investment specialist with over USD 50 billion in assets under management and more than 400 institutional clients. A large,

international team is responsible for managing a wide range of investment programs focusing on private markets, liquid alternatives and multi-asset class solutions. Headquartered in Pfaeffikon (SZ), Switzerland, the firm has offices in North America, Europe and Asia.

www.guernseyfinance.com

www.lgt-cm.com

Nephila is a leading investment manager specialising in natural catastrophe and weather reinsurance risk. Nephila has assets under management of approximately

$9 billion and has been managing institutional assets in this space since 1998. The firm has over 60 employees based in Bermuda, San Francisco, Nashville and London.

nephila.com

SCOR Global Investments (SGI) is the asset management division of SCOR, a top-five global reinsurer. With over EUR 14 billion assets under management, SGI aims to

provide medium to long-term recurrent returns while giving its clients access to asset classes with unconventional beta, such as Insurance-Linked Securities.

www.scor-gi.com

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Since June 2013, Schroders and Secquaero Advisors have joined forces to offer a suite of insurance-linked securities strategies in a truly institutional set-up. We offer a full

range of ILS solutions for various investor needs, from pure cat bonds, managed accounts to an all-ILS fund spanning all instruments and risks.

www.secquaero.com

Sirius Capital Markets provides investors access to returns derived from catastrophe-related (re)insurance exposure, the inherent risk of which SCM believes is distinct from

that faced in the broader markets. SCM’s advantage: leveraging Sirius Group’s global access, expertise and heritage, to complement SCM’s dedicated investment team’s experience in capital markets and property catastrophe risk.

Prime Management, a division of SS&C GlobeOp, has been servicing the specialized requirements in the ILS and collateralized reinsurance market since 2002. As a

licensed Bermuda Insurance Manager and Fund Administrator, Prime has developed best practices geared to the various income allocation methods and fee calculations, while providing transparent investor reporting for side-cars and fund structures.

www.siriuscapitalmarkets.com

www.sscglobeop.com

Twelve Capital is an independent investment manager specialising in insurance-related investments. Its core investment offering incorporates liquid and private

transactions in Insurance-linked Securities and Insurance Debt. The firm provides fund solutions and manages sophisticated tailor-made mandates for institutional clients. It was founded in July 2010 and has around USD3bn AUM.

www.twelvecapital.com

MEDIA PARTNERS

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FOREWORD

The (re)insurance risk convergence capital arena –often

referred to by shorthand as insurance linked securities

(“ILS”) – continues to evolve in a variety of ways and at a

deliberate pace.

The earliest forms of insurance securitisations dating back some twenty years were utilised then by a few leading and capable market participants to transform catastrophic risk (both P&C and Life) in a manner that theretofore seemed unconventional. The risks that were transferred, deal structures, investor offerings and funding mechanisms, at first blush appeared exotic; particularly to mainstream institutional investors unaccustomed to risk assets being packaged in this manner. Back then, the early impetus to access the risk capital markets was mostly driven by innovation from the protection buyer side seeking a broader range of capacity providers.

In the intervening years, the asset class has been tested both through the depths of the financial crisis and large insured industry losses. In that time, the thesis of limited correlation with the broader credit markets was substantiated. Following periods of insured industry loss, new capital re-entered as market dislocations revealed opportunity. As with other alternative assets, while some opportunistic investors rotated to other investments, the sector fundamentals ultimately held, lessons were learned, innovations and core competencies were built upon, and new participants were educated and attracted.

The market has continued on a positive trajectory from its earliest days increasing in size, depth and breadth. As it has grown, institutional investor acceptance broadened with it. Today’s protection buyers include state catastrophe funds and state sponsored insurers, municipal authorities and primary insurance and reinsurance carriers that are household names domestically and internationally. Protection sellers include well known pension funds, leading asset managers, endowments, sovereigns and corporates.

From the protection buyer’s perspective, more recent considerations include: a regulatory environment focused on capital adequacy, solvency and counterparty credit, and a competitive environment that demands greater capital and pricing efficiencies. For them, the reinsurance convergence market offers a deeper pool of risk capital that is secure, diverse, responsive and flexible.

From the investor (protection seller) perspective, historical considerations included market size, transparency, valuation

and structure. The market is no longer considered exotic, but maturing and innovative. Enhancements in catastrophe risk modeling tools over this time period have contributed to greater investor knowledge and understanding. And much has been done – both in respect of direct investments and managed funds – to increase transparency on risk and exposure, simplify structure, and improve disclosure regarding valuations. Such advances are paramount to investor education and comfort with the asset class and its continued growth.

In the past few years, the offering of insurance risk assets as an investment class has picked up pace and access has expanded with a variety of differentiated investment vehicles, managed accounts, ILS funds and reinsurance risk funds. Specialist and professional reinsurer sponsored managers vie for investor attention identifying new ways to transform catastrophe risk beyond the basics of 144A bond offerings. Some of these offerings are competing in the broader universe of traditional catastrophe capacity. Hedge fund interest in the broader insurance and reinsurance arena – as well as managed vehicles that are part insurance risk and part alternative investment vehicle – has the potential to further expand and innovate upon the offerings.

At the time of the writing of this piece, Federal Reserve Chair Janet Yellen, looking to ease concerns from her commentary that suggested interest rates would rise earlier than previously forecast, remarked that the central bank’s historic stimulus will be required for “some time” given the “considerable slack” in the labour market. An extended low-rate environment such as this has the potential to continue to place pressure on portfolio returns. In addition, political risk and social unrest since the financial crisis continue to make headlines, influencing equity and credit markets, and increasing uncertainty. As investors look further afield for portfolio returns, the ILS sector should continue to benefit from fundamental recognition of the value of risk adjusted returns and portfolio enhancement that the risk asset class offers.

Whilst some may question the capacity of (re)insurance risk convergence to absorb new capital, the array of offerings nevertheless continues to broaden and is being taken up by a wider set of investors in search of alternatives. This influx of risk capital, if prudently managed, has the potential to transform long term the way risk is transferred and investors participate in the asset class.

Insurance-linked securities at a crossroads

Michael R. Halsband

President, Sirius Capital Markets

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SPECIAL GUEST ADDRESS

As the Insurance Commissioner for the State of Oklahoma,

it is my primary duty to ensure that consumers are

protected when buying an insurance product in our state

through our insurers. Whether large or small, every policy

purchased represents risks faced by that consumer that he

or she does not want to face alone. The state-based model

of regulation that we use in the United States allows me

and my department to understand and focus on the risks

that are most prevalent in our area. This, in turn, helps the

insurers who take on these risks to price appropriately and

to respond to loss effectively.

In Oklahoma, we know that disasters will occur, we just don’t know when or where. Our best strategy is to learn from each event so that we can lessen the impact of the next one. Our state is home to the National Weather Center, which uses advanced meteorological technology to study atmospheric events around the globe and to predict future events. We host the National Tornado Summit, an annual event with international attendance that provides education on how to mitigate and recover from the impact of tornadoes and severe weather. Additionally, my staff has worked with U.S. Sen. Jim Inhofe to help introduce legislation for a disaster savings account. These accounts would help consumers fund their own home fortifications before a catastrophe and recover after one occurs. But despite our continual efforts to improve our understanding of and preparation for disasters, these events will continue to happen and we will continue to suffer losses.

When disaster strikes, it is critical that I am able to respond immediately, deploy the resources necessary to ensure an efficient response and help facilitate the industry’s efforts to do the same. During my first month in office, I organised a catastrophe response task force to allow my department to coordinate with the industry in preparation for potential disasters. The value this added to the industry, by helping consumers and insurers quickly and efficiently recover following a disaster, was no more self-evident than in the aftermath of the tornado that hit Moore, Oklahoma last year. Although the tornado was on the ground for less than an hour, it resulted in the loss of 24 lives and more than 100,000 insurance claims exceeding $1 billion USD, figures that continued to grow nearly one year later. Fortunately, the preparation of my department and the industry resulted in an immediate response that minimised both consumer losses

and insurer costs through immediate initiation of the recovery process. Following the event, I reached out to regulators around the country to share the best practices that we have developed and used for consideration in their own states.

Recovery must begin immediately following one disaster because the next is coming. This is the reality faced by both consumers and insurers. Following a disaster, it is imperative that insurers have continued access to reinsurance and that the capital markets remain open and available to impacted insurers and their reinsurers well beyond the reach of the disaster. The availability of capital to insurers directly and indirectly through reinsurers provides liquidity which significantly impacts the ability of insurers to continue to provide the type of rapid and efficient response that served the community of Moore and the involved insurers so well. As we continue to develop and improve our mitigation and response plans, we also better define and price these risks within the capital markets, providing a more attractive and accessible investment option.

Capital market investors have many financial instruments available to spread their risks and raise capital. Insurance companies can spread their risks through the purchase of various securities such as catastrophe bonds, as well as by reinsuring their risks through other insurers. The capital markets and issuers have learned to adapt by working together and developing products that spread their risks. I want to encourage you to seriously consider not only the benefits these investments can provide to your own portfolio, but also the benefits they provide to the insurance industry and the consumers we protect.

The importance of capital markets to the insurance sector in a post-disaster period

Commissioner John D. Doak

Oklahoma Insurance Department

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SECTION 1


1.1 INTERVIEW


1.2 ROUNDTABLE

Insurance-linked securities capital: reinsurance industry threat or saviour?1.3 WHITE PAPER

EVOLVING TRENDS FOR MAXIMUM RETURN STREAMS

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1.1 INTERVIEW


Interviewer Interviewee

Jessica McGhie

Senior Publisher, Clear Path Analysis

Andrew Mawdsley

Head of Financial Stability and Information Unit, European Insurance and Occupational Pensions Authority (EIOPA)

Jessica McGhie: How has capital

influx impacted on the dynamics of

the insurance-linked securities (ILS)

sector?

Andrew Mawdsley: We’ve seen a welcome increase in reinsurance capacity reflecting the greater interest amongst investors to explore this area. There have been obvious effects such as the downward pressure on reinsurance pricing and I would say there have been clear waves of activity that have impacted the market.

The initial capital influx put significant pressure on reinsurers but they have responded with innovative methods for capturing the new capital that is entering the sector; including the increased use of sidecars to lever off their existing comparative advantage to sponsor ILS deals. Some traditional reinsurers have opened up asset management arms to be involved in ILS portfolio funds. The second welcome innovation is the increase in the issuance of instruments with indemnity features rather than an industry index trigger. Supervisors always have a fixation with the possibility for there to be a basis risk within these structures and to some degree, indemnity type instruments close that gap.

The final point I wish to make is with regards to investor appetite and the changes subsequent to this shift to indemnity instruments. Historically investors might have wanted the industry index linked securities to provide a clear picture as to what their triggers and payouts would be, whereas now, investors are increasingly

comfortable with insurance risks. That said, the question that remains for us is whether this changed appetite is permanent, as it has yet to be tested. These developments have largely emerged during the last two years where the loss experience has been pretty benign. It will be interesting to see what happens once this begins to change. As supervisors, one of the things we focus on, in relation to the asset markets, is the extent to which there’s potential for a reversal of risk perceptions. In other asset markets such as high yielding corporate bonds, there has been very dramatic spread compression. Equally so, we have seen spread compression in ILS and therefore, we wonder whether this is due to a truly increased understanding of the risk, a perception that it has declined, or is it simply driven by the market’s search for yield. As supervisors we always cast a slightly dispassionate eye on new market developments and trends.

Jessica: Do you think the downward

trend in pricing is a short-term blip or

a new long-term market trend?

Andrew: It depends on how “sticky” this influx of funds might be, particularly when we consider that the market isn’t fully mature. We had a market that was growing dramatically, we had the crash, the market went very quiet and now we are seeing the market start to grow again. In the context of broader asset markets where often yields on safer assets are very low, it’s hard to say yet if the developments are permanent and the

jury is out on whether a reversal will happen.

Jessica: As this ‘alternative’ capital

moves closer towards becoming a

mainstream investment tool, are

opportunities for returns becoming

more or less feasible? To what extent

has ‘saturation’ occurred?

Andrew: Saturation is a difficult concept to capture. When we talk about ILS becoming a more mainstream asset class then certainly investors have greater familiarity with it now. However, in the greater scheme of asset classes it still remains something of a minority interest because it is a fairly specialised asset class. In terms of the relative size of issuance versus the potential pool of investors, certainly there is growth potential because it’s not as constrained by the balance sheet from the investors’ side. The question for us is around how realistic pricing is and whether it is based on a clear evaluation of risk or on the weight of money chasing these assets. There’s no guarantee that rates will remain as low as they currently are and there is an interesting feature here. If you track pricing evolution pre-crisis it appears fairly smooth, post crisis there are points of volatility that have occurred around loss events. This leads one to suspect a degree of sensitivity on the part of investors to loss events but until the market’s truly tested, this is hard to see.

Jessica: Are those pricing concerns

shared by reinsurers?

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Andrew: Hard to say because we approach it from a pan-European supervisory perspective and are consequently one step removed from what firms’ themselves think. We observe developments across multiple asset classes and consider ILS mainly in relation to the broader investment market and therefore, any concerns, are reflective of our overall asset market concerns.

Jessica: 2012 and 2013 were fairly

benign for reinsurance losses but

given that loss can occur in any given

market, should there be broader

participation in the reinsurance risk

pool?

Andrew: The issue is always around whose perspective you’re looking at this from. From a reinsurers perspective I would argue that broadening the risk pool is very welcome, particularly if that pool is one of well informed investors who have a clear understanding of the risks they are taking on. Those investors understand that there can be a total loss with these instruments but equally, that they can get a strong return as a result.

However, if you look at it from the perspective of the investor you start to question what the risks are. Because unless you’re holding a diversified portfolio of ILS, you may face a very concentrated insurance risk related to that individual ILS. It cuts both ways and how people react to this depends on how informed they are as investors. The simple answer is yes, we certainly support a broader risk pool but the lessons of the past have to be taken into account.

One of my roles here is to look at the financial stability of the system as a whole and with a risk transfer of this nature, inter-linkages are created across the financial system. For a long time there was an argument that insurers were not systemically important because they were not so interlinked. Of course it is clear that the more issuance of these instruments

we have, the greater the linkage becomes. It has to be remembered that it was the securitisation sector and the way that investors and issuers behaved within that market, which was really at the core of the crash. Those lessons have to be learned very clearly and therefore, a broad pool is only a welcome development if investors properly assess the risks and make well informed investment decisions.

Jessica: How can traditional reinsurers

integrate capital better into new

investment vehicles and what can

they expect from the regulators?

Andrew: If you think about what comparative advantage a traditional reinsurer has there is nobody better, in terms of understanding reinsurance risks, than the manager of those risks, evaluating reinsurance deals and pricing them. So far reinsurers have tried to utilise this by sponsoring deals and diversifying their activity towards an asset management type of role, which of course moves them away from core reinsurance. Then there is also the use of sidecars which over the last few years have resulted in quite a lot of issuance, particularly on a global basis. Product design is another issue although perhaps that has become a little easier in some ways because of the increased appetite for indemnity type products amongst investors.

One of the key fixations that regulators have with regard to risk transfer methods, like securitisation, is its purpose. The number one issue revolves around whether risk is actually transferred and whether there really is mitigation that can be captured by the ceding insurer. This is very much embedded in the treatment of risk mitigation in Solvency II where there are qualitative criteria set down in

terms of what’s to be expected in relation to contractual arrangements to improve the enforceability of risk transfer. Solvency II provides a much clearer framework across multiple jurisdictions with a more consistent and integrated approach to the supervisory treatment of risk transfer.

There is also the issue of the purpose behind the risk transfer. There are different ways that securitisation type instruments can be used and supervisors are much more comfortable when they see it used for actual risk transfer and balance sheet management rather than for funding; funding-type arrangements will always scrutinised much more closely by the supervisors.

The other issue is around the actual vehicles used to transfer risk so when we think about things like reinsurance, special purpose reinsurance vehicles (SPRVs) it’s very important that they are properly authorised and supervised. Investors and insurers have to be sure that when risk is transferred to an entity that is properly regulated, authorised and subject to solvency requirements that ensure there’s adequate capital within the system to support these sorts of risks. In reality the risk may go off the balance sheet of a given firm but it will still remain within the broader financial system. Therefore for regulators, it’s important that wherever it’s end destination is, there is appropriate capital there to support the risk.

Jessica: Thank you very much Andrew.

“Supervisors always have a

fixation with the possibility for

there to be a basis risk . . .”

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1.2 ROUNDTABLE

Moderator


Aashh K. Parekh

Managing Director, Global Public Market, TIAA-CREF

Dan Bergman

Head of Investment Research & Insurance-Linked Securities, AP3

Dirk Lohmann


Steve Evans

Owner and Editor, Artemis.bm

Steve Evans: Is there a drive towards

broader participation in the

reinsurance market?

Dirk Lohmann: If you define insurance-linked securities (ILS) as capital markets I would say yes; although the question is around what form that capital market participation will be. There have been recent developments amongst new reinsurers, backed by hedge funds, to focus increasingly on areas such as casualty. That said, I don’t know the extent to which they are really involved in reinsurance; I rather feel it is more a method for securing permanent capital for hedge funds. This increased amount of capital includes a lot of sidecar involvement which technically, allows investors to participate in a broader range of reinsurance than would be the case if they were limited to bonds.

In ILS specialist funds where managers have their own transformers, there is an increasing trend of investing in non-catastrophe related risk that may be short-term in nature. One such manager recently announced they also invested in per risk transactions and I see activity likely to continue in that direction.

Aashh K. Parekh: At TIAA-CREF we work with many different accounts all of whom have varying degrees of interest in the broader reinsurance market. Essentially it depends on how

the ILS market reacts to the current dynamic. We’ve experienced some spread compression in insurance-linked securities, also known as catastrophe (CAT) bonds.

The answer to this question depends on whether or not demand can be met with supply through the traditional securities market; if the supply continues to be constrained, despite the fact that spreads have compressed, ILS will be competitive with reinsurance markets in some places. If that increased demand isn’t met with increased supply, then some of our accounts will find it compelling to expand capabilities and branch out beyond traditional CAT bonds.

Dan Bergman: I’ll take the starting point to be how we act and what types of investments we might consider as part of the broader reinsurance market. We are in this market for the long-term in order to get good risk adjusted returns and diversify our total portfolio. As a pension fund we invest globally in a broad range of asset classes but still, our portfolio risk is dominated by equities. Consequently we value asset classes with good risk adjusted returns, not correlated with equities; ILS provides just that, it diversifies and improves the efficiency of our total portfolio.

Thus, a natural strategy for us when building our insurance exposure is to invest in a smaller number of well- priced risks. We don’t presently feel a need to access new types of risks or perils, rather we focus on finding well priced risks that we can access efficiently. This may differ somewhat from, for example, a hedge fund dedicated to this space (or a traditional reinsurer for that matter) where the entire risk can be insurance or CAT related. I don’t see a strong interest from our side to grow this market into new areas; our strategy does not require that.

Isaac Anthony: We definitely believe there is a drive towards broader participation in the reinsurance market through multiple fronts, as ILS investors become more sophisticated and develop their in-house underwriting capabilities. At CCRIF we are very reliant on the reinsurance market and are actively trying to source the best pricing. This year we are seriously looking at the possibility of getting involved with CAT bonds and potentially, collateralised reinsurance. From our perspective this is very important as we feel this market expansion presents us with some excellent opportunities.

Dirk: To add to that, I would put the question out there as to why there is an interest in this broader

Isaac Anthony

Chief Executive Officer, Caribbean Catastrophe Risk Insurance Facility (CCRIF)

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participation; the answer of course being the diversification offered by this asset class. The bond universe alone is highly concentrated by U.S. wind which in turn has generated some very significant quake aggregates, as many national accounts sponsoring bonds that are principally exposed by hurricane also throw in the earthquake risk as a secondary peril. This is all fine and good if you’re taking the AP3 approach, for example, where you say we don’t need diversification within that asset class because it naturally diversifies against other asset classes and because your allocation is going to be small. Certainly there is an investor base out there allocating to managers like ourselves in order to gain both the diversifying and non-correlating nature, and are equally desirous of limited draw down on their investment.

The reality though is that if you have a bond only strategy the draw down risk on the principle that you commit can be quite severe, simply because of the high concentration of hurricane risk in the bond universe. This has caused a proportion of investors to increase the amount of diversification that they seek.

Aashh: When we compare the characteristics of the ILS market components to the other capital markets that we participate in, one thing we observe is that the ILS market isn’t as mature as other markets. Whilst there is a fairly active primary risk pipeline the secondary market is not very well developed and frequently it is the case that there isn’t much liquidity.

Secondly, the broader reinsurance market brings other types of risk to the table that aren’t observed in the ILS market. Moreover, it’s frequently the case that even for the same peril, with some adjustments for risk profiles, documentation and contract language, you can actually be paid more for taking on similar kinds of risk but in a different format. From that standpoint our investors are on a risk adjusted basis looking for the most return and

in some instances would find other reinsurance formats, not just ILS, equally compelling.

Dan: The pull-back of many of the larger traditional U.S. insurers from coastal areas has left substantial hurricane exposure with different residual markets. Over the past couple of years we have seen how more and more of these risks have found their way to the collateralised reinsurance market and even the 144A CAT bond market. I expect this development to continue and it is certainly beneficial to these coastal communities to obtain coverage for their hurricane risks at competitive price levels. This is one example where the development of the ILS-market serves society well.

Isaac: On a standalone basis we are seeing increased interest in energy, marine and agriculture. There is also extremely high demand for the non-peak national capacity perils because they appear to be offering greater diversification and good value for regions such as the Caribbean, Central and South America. This is ultimately driving pricing convergence within traditional markets and additionally, the various buyer are then helping to provide multi-collateral capacity, which further increases market competitiveness.

Steve: What are the present

constraints on the key market players,

from the asset owner, insurer and ILS

provider’s perspectives?

Aashh: Spreads are tighter in the current market environment relative to 12, 18 or 24 months ago. From a risk standpoint it is additionally challenging for some markets to achieve the desired amount of diversification just by participating in CAT bonds alone. In terms of diversification, we’re talking

about perils and peril regions as well as the number and type of cedants. I would say the ability to diversify in the ILS market is improving but overall investors are still limited in other formats. These are the main constraints from the asset managers’ standpoint. From an insurance company’s standpoint, some accounts are sensitive to the existence of ratings even though ratings have limited application in this asset class.

Dan: The spread compression in the broader insurance market and in particular in the listed CAT bond space has forced us to work harder and reduce our participation on several programmes. We are increasingly focusing on the traditional market and various types of private transactions in order to find better risks and pricing.

Dirk: It’s an important consideration but more significant is the relative size of the market. It’s still tiny and for many larger institutions if they want to make a meaningful allocation it’s hard to find enough product to satisfy that. There are huge institutional investors that understand the benefits of this asset class from a portfolio context but to move the needle on their diversification, will need to allocate several hundred million dollars. Even though the total bond market size is worth $22 billion, it’s not very big and there’s not much liquidity. It’s a niche market and therefore this will always be a problem until we are able to develop additional products with meaningful value for the insurance company sponsors and are fungible, in a way that institutional investors or

“this market expansion presents

us with some excellent

opportunities”

15



capital market investors can own and trade them.

Isaac: From a buyers protection perspective, there are some trade-offs in the terms and conditions of traditional markets. For example, CAT bonds and many of the collateralised reinsurance providers cannot provide reinstatements on a cost competitive basis within the traditional markets. There will be some parts of the reinsurance programme better suited to alternative markets than others and therefore, it’s important to understand and optimise how the different markets utilise the specific instruments.

Steve: The ILS marketplace isn’t

as diversified as the traditional

reinsurance market, where do

you expect the greatest level of

diversification and expansion to

occur?

Dirk: The reality is that if you’re talking about catastrophe risk there is only limited growth in emerging catastrophe markets. These are markets where insurance penetration is increasing and where consequently, there are capacity constraints; that’s a vision of the future, let’s say in China in 10 or 20 years or so. Over the last 6 to 10 months there has been an increasing use of aggregate type structures and protection against frequency, as well as severity. This has been one of the drivers behind increased issuance by a number of sponsors who might not have normally entered the market. To a certain degree this does add diversification, at least from a temporal aspect, in that you

are more likely to be exposed on the second, third or fourth event rather than first. That said there are limitations because if everyone buys that cover then of course you will have tighter correlation within the portfolio. It’s tough to say.

Some people might say that they’ll look at terrorism because there’s been talk about TRIA not being renewed, when in reality it actually is being renewed. I am not a big fan of terrorism as a product for the capital markets because I don’t believe it is non-correlating; in fact terrorist events have a high correlation with capital market movements. I suspect there will be increased movement towards other perils that historically, have not been insured to a great extent, such as flooding. For this to happen there needs to be improved modelling, time and resources; however, we’re making some progress with reporting agencies such as PERILS AG, who are increasing their footprint coverage and really moving modelling on.

Isaac: Speaking more from a geographical rather product development perspective, I certainly see the greatest push to be into international emerging market zones. There has been a recent application of transactions in the Caribbean with growing interest in Central America and to a lesser extent in South America, including in Columbia, Chile and Peru. In Asia, the biggest developments have been in China and Taiwan and collectively I see this growth as the driver behind greater levels of diversification.

Dan: It’s not obvious to me that this market will expand significantly but again it depends on how you define the ILS market. Presently we see issuance from various new diversifying

sources. This is in my mind is largely driven by the current attractive pricing (from the cedents’ perspective) and it may not be sustainable, although it can of course continue alongside a soft market for a number of years. I struggle to see it persist for the long-term. I would rather assume a moderate more gradual growth, largely driven by an increased familiarity with non-traditional capacity within smaller and mid-sized companies, particularly in the U.S. As a consequence, I expect much of the long-term growth to occur in the collateralised private space rather than in the listed 144A securities space.

Steve: There is an increased

acceptance of indemnities and

subsequently we’re seeing more

features such as variable resets

and expansion of the terms

and conditions. Which new ILS

instruments are most appealing and

why?

Aashh: Anything that increases risk for the same price is not appealing to us. That said there are some things that we are willing to live with and others we are not willing to live without. Therefore we’re constantly re-evaluating where that line gets drawn and where the grey area is; it’s a moving target. Generally speaking, we have made the same observations that you have, in terms of the type of risk that makes it to market, the format of the risk and the nature of the portfolio, documentation, triggers and structural features. We see it moving in a direction that is reflective of the state of the market. In some cases we can find situations where it’s acceptable and in other cases they’re not acceptable.

Dan: My general reflection is that: cleaner is better. We see relaxed terms, an increasing number of more involved structures and some new securities with perhaps more complex underlying books of business coming to market. We struggle to find value in some

“the ability to diversify in the ILS

market is improving. . .”

16



of these more complex and creative transactions.

Dirk: I echo many of those comments but add that it’s welcoming to see so many new sponsors coming to the market and broadening the number of participants. What does concern me though is that, as Dan mentioned, at times there are quite complex portfolios being put to the markets, priced off a model in which the model risk is very large.

We’re returning to a situation that we had in 2005 when a bond was placed on an industrial portfolio with the model defining the expected value as ‘x’. However, when the event happened the triggering threshold event was well below the ‘x’ that the model had predicted and so the risk/return profile was off.

It is because of these situations that we have to be very vigilant regarding what type of portfolio is insured, on what basis and when an indemnity trigger is used for transferring all of that risk into the capital markets. This reflects where the marketplace is today but that said, there may still be corrections needed because who knows what surprises are yet to come. Whilst some extensions might make sense for certain types of perils, the biggest concern remains around the incorporation of portfolios that are priced with a huge model risk.

Isaac: Although we are relatively new to the market, we do see that the collateralised reinsurance and CAT bond markets are very attractive options for sponsors. The main advantage of these, certainly from a collateralised reinsurance market, is in the execution process and the additional coverage that is provided. We also recognise that CAT bonds introduce a multi capacity and a broader range of investors into the marketplace which of course helps influence our decision. These instruments provide strategic benefits in that they broaden the source of capacity over time which in turns

helps better manage volatility in the reinsurance market.

Steve: Thank you all for sharing your

insights.

The material is for informational purposes only

and should not be regarded as a recommendation

or an offer to buy or sell any product or service to

which this information may relate. Certain products

and services may not be available to all entities or

persons. Past performance does not guarantee

future results.

TIAA-CREF Asset Management provides investment

advice and portfolio management services to

the TIAA-CREF group of companies through the

following entities: Teachers Advisors, Inc., TIAA-

CREF Investment Management, LLC, and Teachers

Insurance and Annuity Association® (TIAA®).

Teachers Advisors, Inc., is a registered investment

advisor and wholly owned subsidiary of Teachers

Insurance and Annuity Association (TIAA).

C16304

“there has been an increasing use

of aggregate type structures. . . ”

17


1.3 WHITE PAPER


Dr. Urs Ramseier

Partner, Chairman of the Board of Directors and Chief Investment Officer, Twelve Capital

John Butler

Partner, Head of Sourcing and Underwriting, Twelve Capital

ILS market overview

The insurance-linked securities (ILS) market has grown significantly in recent years, and is now estimated to be worth US$ 45 billion.

Roughly US$ 20 billion of this is invested in catastrophe (CAT) bonds and US$ 25 billion in private ILS transactions. Demand from investors exceeds available transactions, and more capital waits on the sidelines. New capital inflows have caused CAT bond spreads to compress significantly and put pressure on reinsurance rates.

What is driving the popularity of ILS?

Global pension funds are the primary ILS investors. Yet the number of pension funds that have opted to invest in ILS is still relatively small, and they have only allocated an average of 2-3% of their total investments to this asset class. However, an increasing number of pension funds have started tracking and analysing the risk and return of ILS investments, and many of these may well invest in the next 2-3 years.

What attracts these investors to ILS? It is the simple but powerful fact that natural catastrophes – and many other insurance risks – are fundamentally uncorrelated to any other asset class. As a result, the investor gains a diversification benefit by adding ILS to an investment portfolio. Any uncorrelated investment is beneficial within a portfolio, even if returns are lower than on equity or bonds.

ILS investors target the most profitable lines of business. These are typically natural catastrophe risks – chiefly U.S. hurricane exposures. These risks are the easiest to securitise: the pricing is the most attractive of all natural perils; the risk period is short; the risk is well modelled; and there are reliable agents to calculate the industry losses that – in the case of industry loss trigger transactions – can determine eventual transaction losses.

Why does reinsurance equity not offer the same benefits to

investors?

There are three forms of capital available to the reinsurance industry:

either by means of fully collateralised mechanisms (ILS)

or on a contingent basis (e.g. reinsurance companies or Names at Lloyd’s)

Equity is the most expensive form of capital for the (re)insurance industry. Thanks to its diversification benefits, ILS is the cheapest. The most popular form of investment for those looking to enter the reinsurance market was, prior to the birth of ILS, equity offered by traditional reinsurers. However, returns on equity are eroded by company management costs and the tendency of reinsurers to diversify into less profitable lines of business. In addition, financial market investments on the asset side of the balance sheet expose reinsurance shareholders to additional financial market risks. A listed reinsurance stock thus has the disadvantage of being highly correlated to equity markets in general.

So, what ought to be a fundamentally uncorrelated investment gets transformed into a correlated investment, and the diversification benefit is lost. The investor is also exposed to the risk that the management of reinsurance companies might not always act in the best interests of shareholders.

As insurance investors focus on those lines of business that are favourably priced and soundly modelled, reinsurance companies might end up losing their most profitable lines to the ILS market. And it is this source of profit that reinsurers have traditionally relied upon to support and cross-subsidise substantial volumes of business that generally only break even. With profitable lines taken away by more efficient investors, reinsurance companies are left with business models that cannot sustain conventional cross-subsidisation.

What’s the future of the reinsurance industry?

The reinsurance industry is likely to continue growing faster than GDP as new business opportunities open up in emerging markets. But there is a fundamental step-change happening in the financing of large insurance risks. Given that ILS capital has lower cost of capital than reinsurance equity, the shift from reinsurance equity capital to ILS will continue.

ILS investors will further explore investments in non-peak perils including man-made risks, such as fire or terrorism, or even casualty lines of business. Investors may also use financial leverage to improve the risk-return of ILS portfolios.

18


This means that, although the industry as a whole is growing, reinsurance balance sheets will most likely stagnate, or even shrink. Reinsurance companies will be forced to optimise their balance sheets in order to lower their cost of capital. Only those with efficient balance sheets will survive. The focus on cost of capital will lead to:

markets

Important insurance events, such as large earthquakes or hurricanes, help accelerate the growth of the ILS market. Insurance investors are well aware that the best time to tactically allocate to ILS is after a large event. Therefore, significant capital sits on the sidelines, waiting to be invested as soon as reinsurance premiums increase. As ILS funds are also able to supply new capital to the market far quicker than reinsurance companies manage to raise equity capital, reinsurance premiums are likely to become much less cyclical in the future.

In summary

ILS capital is lowering the average cost of capital for reinsurance risks and will drive a structural shift to lower reinsurance premiums. This will benefit clients, primary insurance companies and individual policyholders. Conversely, reinsurance balance sheets will struggle to hold steady in the face of changing market dynamics.


“…reinsurance premiums are likely

to become much less cyclical

in the future.”

Cost of Capital to drive Capital Allocation

ILS: Maximize

Maximize

Minimize

Cost of CapitalDirect Insurance Balance Sheet

Cash

Re-insurance Receivables

Bonds

Equities

Real Estate

Technical Reserves

Debt

Equity

Other Receivables

Source: Twelve Capital.

“…ILS capital is lowering the

average cost of capital for

reinsurance risks and will drive

a structural shift to lower

reinsurance premiums.”

Return on Insurance

Twelve Capital is an independent investment manager specialising in insurance investments. Our core investment offering incorporates liquid and private transactions in Insurance-linked Securities (ILS) and Insurance Debt.

Both investment segments benefit from our team’s significant experience in the insurance sector as well as capital markets, including in-depth expertise in deal sourcing, analytics, structuring and risk management.

We give institutional investors access to a compelling range of insurance-related strategies, and we generate attractive-risk adjusted returns for them.

Twelve Capital provides fund solutions and also manages sophisticated tailor-made mandates.

Twelve Capital was founded in July 2010 and is majority owned by its investment team. We currently manage over USD3bn.

Twelve Capital AGDufourstrasse 101 | 8008 Zurich

Switzerland

[email protected] www.twelvecapital.com

20


SECTION 2

Above and beyond–why insurance-linked securities have to evolve beyond catastrophe risk



2.3 INTERVIEW

2.2 INTERVIEW

2.1 WHITEPAPER

THE CATASTROPHE BOND EVOLUTION

21


This year the securitisation of non-life insurance risk

celebrates its 20th anniversary. In 1994 Hannover Re

sponsored the issuance of $100 million in notes linked to

the performance of a portfolio of catastrophe reinsurance

risk assumed by a Cayman special purpose vehicle, Kover

Ltd. This modest transaction heralded the beginning of a

transformation in how institutional capital enters into the

reinsurance market. For the first time, capital markets could

invest in temporary capital whose returns were linked to

pure insurance risk and not correlated to the returns of

financial assets typically held by reinsurance companies

who financed themselves by issuing permanent capital

(equity) and long term debt. Our belief is that in order

for this asset class to live up to its promise of becoming a

meaningful alternative for institutional investors, it will

need to evolve beyond its current focus on catastrophe risk.

From its humble beginnings some 20 years ago, what is broadly defined as the alternative capital market for reinsurance risk has today grown to an estimated size of $50 billion in allocated capital*. This comes in various forms, the most commonly known of which are cat bonds, presently representing about $20 billion of outstanding issuance, with the remainder committed to private collateralized reinsurance contracts (often referred to as financial insurance contracts) or investments in sidecar reinsurance vehicles. The vast majority of this alternative capital is committed to assuming catastrophe risk. There are a number of reasons for this. First, catastrophe risk – particularly for peak risk exposures – is quite capital intensive. Transferring this risk to alternative capital providers is quite efficient and has led to a general “win-win” situation with sponsors gaining capital relief at relatively low cost and capital market participants gaining access to a truly diversifying asset with positive absolute returns. Second, catastrophe reinsurance is a fairly standardised product lending itself to syndication, be it in tradable 144A cat bond format or as private collateralised reinsurance. Last not least, for the non-insurance specialist investor the concept of placing capital at risk against extreme and rare events was an intuitively simple concept to grasp and convey to superiors and governance bodies. Charts 1 and 2 provide an overview of aggregate historical issuance and current outstanding volume of insurance securitisations (excluding life embedded value, reserve securitisations and longevity transactions). As this excludes most side cars and private collateralised reinsurance, almost all of which is focused on catastrophe reinsurance, it actually understates the predominance of catastrophe risk.

Overall an impressive first 20 years, but measured against total global debt market of some $98 trillion or pension assets of $32 trillion, the total market size still represents a challenge for institutional investors wishing to make a meaningful allocation to reap the diversification benefits offered by this asset class. So what are the prospects for the future growth of the asset class?

Here the answer is more nuanced. We would argue that the potential is enormous, however, the prospects for growth are more limited if one restricts the definition of the opportunity to event driven risk transfer in the form of property catastrophe reinsurance. Why is this so? Quite simple: the market demand for property catastrophe reinsurance is modest. Estimates by a leading reinsurance intermediary, Guy Carpenter & Company LLC, estimate the total size of aggregate catastrophe limits purchased at approximately $300 billion. That means that the alternative capital market already has achieved a market share of 15 to 16% of the global reinsurance demand for catastrophe risk transfer. Last year in Monte Carlo Swiss Re estimated that the growth in demand for catastrophe protection in developed insurance markets (where the capital markets currently play a significant role) would grow by 50% between 2012 and 2020, representing a compound annual growth rate of just over 5% per annum. Unfortunately, net capital accumulation within the reinsurance industry (after dividends and share buy backs) has outpaced growth in aggregate demand. AON Benfield Analytics estimates that net capital within the traditional reinsurance industry has grown by 7% per annum over the last two years. Including inflows from alternative capital providers the total global reinsurance capital in the sector is estimated to have grown by 8.9% per annum over the same period. This has resulted in the typical cyclical phenomenon of declining rates in traditional reinsurance markets for catastrophe risk transfer. The result, invariably, has been margin compression but due to the lack of other viable alternatives, no real abatement of capital inflows into the sector.

So where will or can the future growth come from? Some market participants point to state sponsored schemes, be it wind pools in developed markets or government insurance mechanisms in emerging markets, as possible sources of additional supply to the alternative capital markets. While there is still scope for growth, the aggregate impact on demand represented by such entities will be less pronounced as much of this risk is actually already reinsured with traditional reinsurers and is now simply beginning to access alternative capital in addition

Above and beyond: why insurance-linked securities have to evolve beyond catastrophe risk

Dirk Lohmann


2.1 WHITEPAPER

22


to, or in lieu of, traditional reinsurance capacity providers. Real potential may exist if governments were to consider insuring infrastructure and government property, presently one of the largest sources of gap between insured and economic loss. For this to occur, government’s approach towards financing disaster relief and reconstruction would have to change, something that may be a challenge given the budgetary constraints that all governments presently face. Emerging insurance markets, such as China, could prove to be sources of future demand, but at present the insurance penetration and aggregate sums insured remain at modest levels that can easily be satisfied by traditional reinsurance markets. Others point to such risks as terrorism where presently government backstops support the private insurance industry. Our view here is that although demand for limits may be significant, we are yet to be convinced that such events are truly non-correlated to movements in the financial markets – one of the key selling points for investing in insurance linked risk.

In thinking about potential future areas for growth we divide the universe into two categories: event driven and portfolio linked transactions. In the event driven field we have seen some bond transactions such as Golden Goal, providing event cancellation coverage to FIFA for the 2010 World Cup; Avalon, the industrial accident bond sponsored by OIL Casualty Insurance Ltd providing it protection against a frequency of large liability claims arising out of accidents impacting energy related enterprises and Golden Gate, a bond providing a state workers compensation fund with protection against an accumulation of loss through an earthquake event. Each transaction represents an interesting experiment in introducing new classes of insurance risk (contingency, liability and workers comp) to the capital markets. Of the three, Golden Gate represents an extension of the catastrophe market into offering event driven protection to other lines of insurance that are exposed to the same event as the property catastrophe bonds. Looking beyond these historic examples, we note that events such as Deepwater Horizon, Costa Concordia or the recent train derailment in Lac-Megantic, Canada have highlighted the potential for man made disasters where the available insurance limits are potentially insufficient to properly address all damages arising from such calamities. A challenge for all man made disaster type event driven contracts is the need for an objective loss trigger that can serve as a reliable indication of whether investor’s capital is at risk or not. If the coverage for the event includes insurable interests beyond simple physical damage, such as third party claims for bodily injury or economic damages, then it could take years to determine what the ultimate insured loss is as multiple insurers and policyholders may be involved in the event. Presently no independent agency or reference source exists that collects and aggregates industry-wide insured loss information for such events. Therefore, until new reporting sources can be agreed upon or potential sponsors wish to assume basis risk by purchasing cover on certain objective criteria (such as number of lives lost) the potential for growth

in this area – at least in the form of publically issued bonds - will be limited. We are seeing some first developments of alternative capital involvement in man-made disasters through private collateralised reinsurance structures and expect that most growth will be in this area for the foreseeable future.

In our view, far greater potential lies in the area of portfolio linked securitisations where alternative capital providers offer sponsors protection against a shift in the subject insurance portfolio’s overall behavior and a single event cannot result in the impairment of the instrument. Here two structures are typically applied: the quota share and the stop loss. Up to now the quota share is the mechanism that commonly underlies the reinsurance side-car concept, which has principally been another way for alternative capital to participate in catastrophe risk on a portfolio as opposed to an individual risk basis. In life insurance the quota share has been commonly used to finance new business growth or monetise the present value of future profits through embedded value transactions where in addition to providing cash financing through the payment of ceding commissions, the reinsurer or alternative capital provider has assumed the risk of shifts in mortality or lapse experience from expected best estimate projections. Another form of portfolio-linked protection available to an insurance sponsor is stop loss reinsurance. Properly structured, alternative capital providing stop loss protection can prove to be a very compelling and efficient form of senior capital to help insurance company managements optimise their overall capital structure and return on equity. In fact, for large insurance groups with multiple operating entities, parent company stop loss reinsurance has been an instrument that has been recognised by rating agencies and regulators as a viable capital surrogate for downstream subsidiaries, thus allowing a more efficient use of capital on a group level. Non-life stop loss reinsurance placed with external non-group reinsurers on a risk transfer basis has principally been focused on short tail lines often written by mono-line specialist insurers such as crop, hail or building insurers.

Embedded value financing reinsurance has been a mainstay activity of many professional life reinsurers and there were a number of such securitisations prior to the outbreak of the financial crisis. Unfortunately, these transactions relied heavily upon principal and interest guarantees provided by financial guarantors so that ultimately these transactions hinged not so much insurance risk transfer as on the counterparty risk of the guarantor. Since 2008 only two embedded value transactions have been placed with alternative capital markets (without the “benefit” of financial guarantees), although the volumes conducted in the traditional reinsurance markets have continued to be quite significant. Within Lloyds, non-life multi-line stop loss structures have been used as capital surrogates in the form of so-called capital provision stop loss covers that have enabled syndicates to gain regulatory capital credit and expand their writings by using capital that was less expensive than the equity provided by names. In the capital


23


markets there have to date only been three sponsors who have adopted the use of portfolio linked stop loss structures with the objective of achieving ratings agency or regulatory capital relief. These were Swiss Re’s Crystal Credit, AXA’s SPARC Motor securitizations and Aetna’s Vitality Re securitizations covering group health business. The first two were principally focused on achieving ratings agency relief, while the last was clearly focused on reducing regulatory capital to enhance return on equity and provide additional capacity for growth. The performance of the Crystal Credit transaction, which resulted in a loss of principal to the junior tranche, demonstrated that this type of structure might not lend itself to all lines of business. The underlying business in Crystal Credit was, as the name suggests, trade credit insurance where losses proved to be highly correlated to developments in the macro-economic cycle and hence not fully fortuitous in nature. AXA’s SPARC transactions and Aetna’s Vitality transactions, on the other hand, have proven to be excellent case studies of using alternative capital structures to enhance and optimize the sponsor’s overall capital structure while at the same time providing investors with new and diversifying non-event driven insurance linked investments. While all three structures placed with capital markets were mono-line in nature, we believe that the greatest potential long term may lie in replicating the Lloyds capital provision stop loss structures for insurance companies outside of Lloyds.

A challenge for these structures will be the ability to translate the attachment point for the stop loss into something that can be easily understood by a non-insurance specialist investor. Swiss Re’s Crystal Credit and AXA’s SPARC motor transactions did not provide investors with an expected loss validated by an external agent and instead relied on default ratings provided by external rating agencies. Aetna’s Vitality Re securitisations did use an external expert and secured default ratings from Standard & Poor’s, but for investors without own in-house actuarial expertise this was something that was not easily independently verified. As we contemplate possible new applications we will have to develop a method of communicating probabilities to external providers of

alternative capital. Some of this may simply come down to improved disclosure, but this would still require the requisite in-house expertise to assess the data. One possible approach might be to link payouts of principal at risk insurance linked securities to other measurable criteria such as solvency ratios as determined by standard models or market loss ratios. A recent contingent capital transaction sponsored by Swiss Re linked the principal loss to either a specified event (U.S. Hurricane with a PCS loss of $130 billion) or a drop in their solvency ratio below a given level. Although the formula for calculating the solvency ratio was based upon a proprietary model that was not made public, it does show a possible direction of how the market could develop. ISO has begun publishing industry wide loss ratio indexes for specific lines of business on a calendar year basis. These might also serve as proxies or benchmarks that can be calibrated to an individual sponsor’s portfolio to provide external market participants with independent and objective references. In addition, to achieve regulatory and ratings agency credit, mechanisms will have to be found to crystallise the obligations under the insurance linked security issued. This could be a loss of principal as is presently the case with instruments covering catastrophe or shorter tail risks where it is relatively easy to quantify the magnitude of loss within a relatively short time frame, or for longer tailed lines it may be to convert the capital from a debt obligation to equity or a non-cumulative preferred class of shares where the conversion is contingent upon certain thresholds being breached and settlement or conversion rate (if to equity) dependent upon the final ultimate loss development.

As we have pointed out in previous papers, we estimate that catastrophe reinsurance only represents about 10% of the total risk transfer premiums paid to professional reinsurance companies. That means that the potential opportunity set for alternative capital is potentially much larger, if one can find the appropriate structure that meets needs of insurance company sponsors and fulfils the requirements of a capital market investor.


89%

5%

2%1% 1% 1% 1%

Total ILS Bond

Issuance 1994 - 2013($59.2 billion)

CatExt.MortalityMotorCreditCasualtyHealthOther

Source: Goldman Sachs, Artemis, Secquaero Advisors AG

*These figures exclude life embedded value and XXX / AXXX reserve securitizations issued prior to 2008 as these relied predominantly upon credit enhancements provided

by financial guarantors and were predominantly sold to ABS investors and not as principal at risk insurance-linked investments.

ILS Bonds Outstanding

as at 31.12.2013($20.6 billion)

Ext.MortalityCat

HealthOther

92.5%

4.2%

2.9%0.5%

*Source: Schroders, as at 31 March 2014. For professional investors or advisers only. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested. Issued in April 2014 by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registered number 1893220 England. Authorised and regulated by the Financial Conduct Authority. w45337

Schroders manages in excess of $1.3 billion* in insurance-linked securities strategies, using the expertise of our exclusive investment advisor, Secquaero Advisors.

We offer a range of ILS products for various investor requirements in a truly institutional set-up.

For more information please contact: Tim van Duren, Product Manager ILS

[email protected] +41 (0)44 250 1256

Insurance-Linked SecuritiesCombined strength

25



Adam Beatty


Sarah Mortimer

Account Director, rein4ce


2.2 INTERVIEW

Sarah Mortimer: What is the

investment case for insurance-linked

securities (ILS) instruments?

Adam Beatty: The fundamental attraction of this asset class is its lack of correlation to other investment strategies such as equities or debt. The lack of correlation makes this a very diversifying asset class for investors and in addition to that it demonstrates a positive expected return over time. In our view, insurers will continue to pay reinsurers a premium to take away the volatility of exposure to large natural catastrophe events. That is still much more efficient for them than holding capital against those remote probability catastrophe events.

Sarah: Is it still the case that investors

invest in this asset class with

dedicated ILS funds or are more

investing directly?

Adam: It’s possible to approach the market both ways; although there isn’t really an investable beta option here. It’s difficult for investors to access the market directly apart from through the catastrophe (CAT) bond market. Many investors choose to use a manager and hence access that manager’s expertise in the area of risk evaluation. They also tap into their expertise in risk origination so they can leverage the manager’s relationships with counterparties and brokers.

Sarah: How does the CAT bond

market fit into the broader

catastrophe reinsurance market and

what other ILS instruments make up

the wider investible universe? What

advantages and flexibility does this

bring as opposed to a CAT bond only

approach?

Adam: Last year we saw an annual issuance of CAT bonds of approximately $7 billion. Since CAT bonds typically have a 3 year duration, the total outstanding volume of CAT bonds in issuance is approximately $20bn. This can be compared with the overall catastrophe reinsurance market which sees something like $300bn of annual notional limit traded each year. The CAT bond market can be characterised as a relatively small pond in a vast ocean of available risk.

The CAT bond market tends to focus particularly on U.S. hurricane risk which means that there is a large degree of concentration to that particular peril and generally speaking, this tends to focus on the more remote risk type events. There is a much broader risk universe out there and our view as a manager is that there is a lot of value in being able to transact across the entire market. Managers that have the ability to originate a broad set of risks can see a lot of business and have a far larger investible universe than someone who’s solely restricted to the CAT bond market. To simplify slightly, if you are able to choose from more potential positions that have some differentiation between them, then it should be easier to create a portfolio that demonstrates more diversity. By this I mean less tail risk for a given level of return.

Sarah: Are you talking about

diversifying into other perils or using

other ILS instruments to do this?

Adam: A little bit of both. Certainly there will be a combination of perils, namely U.S. hurricanes and earthquakes, Japanese typhoons and earthquakes and European wind. Those 5 peak perils usually represent the best value for investors, in particular U.S. hurricane risk. However, the primary diversification I’m talking about is entering that broader reinsurance market and diversifying into other contract types. The majority of the business is transacted as traditional reinsurance; an illiquid, usually annual, over-the-counter reinsurance contract.

Many of these contracts are traded annually in the market and in addition there also other contract types for consideration which you may be somewhat familiar with. These include, for example, Industry Loss Warranties (ILWs) where the contract triggers are based on an estimate of the overall losses to the industry or some index derived from those estimates.

Sarah: What advantages and

flexibility does this bring?

Adam: The fundamental issue there is whether you want to be restricted to selecting a portfolio from a relatively small sub-set of what is a much larger market? Basic portfolio theory leads you to believe that if you had a larger investible universe and as a manager you were able to access a lot of risk, then that added amount of choice could only benefit the portfolio. This is where a certain size, trading history and good relationship with brokers and counterparties prove very helpful.

26


The CAT bond market is not the whole CAT market

Sarah: Could you outline your recent

proposition in the Lloyd’s Insurance

market?

Adam: Nephila began underwriting at Lloyd’s in August 2013 with our initial mandate being to underwrite some of the more structured index based type contracts. We see tremendous value in Lloyd’s as an underwriting platform because it has a great global reputation, international licenses and is a very established trading infrastructure familiar to a lot of counterparties. We are able to bring in new capital and a new product to the market. We’re very excited about the potential to grow that platform over time.

Sarah: What spread compression can

the market expect as a result of the

ILS instrument evolution?

Adam: In our view, the long-term pricing trend for peak catastrophe risk is likely to be downwards - this is to be expected and should not come as a surprise. We’re seeing new capital coming into the market with a different investment motivation than perhaps some of the previous incumbent capital had. This capital is fundamentally attracted to the lack of correlation of catastrophe risk. That lack of correlation is valuable to the investors and generally means that the required return for the uncorrelated asset is less than it would be for a correlated asset.

We are characterising a lot of the new capital as “efficient capital” and over time we predict that a lot of the peak catastrophe risk will get refinanced into this more efficient capital base which will result in some lower clearing price for that future peak risk.

The genie is now out of the bottle with market forces now acting rather than it being controlled by particular investors, managers or counterparties. The spread compression is to be expected over the longer term but that doesn’t necessarily mean that

we’re going to see pricing inexorably dropping each year. It’s highly likely that market dynamics will shift year on year and so the particular supply and demand dynamics may mean that there’s still some cyclicality in the pricing of catastrophe risk. The obvious example would be after some loss activity but the long-term trend for the sector is probably towards lower catastrophe pricing, although the level of pricing will still need to be providing adequate returns and margins for that capital.

Sarah: How do you expect the market

to grow and increase the amount

of risk transferred? Is it on track to

match new capital with new risk?

Adam: The market will grow for a number of reasons. Firstly there will be incremental economic growth as we see an increased number of properties and hence insurable value being constructed in catastrophe prone areas. The new capital coming into the catastrophe market, attracted by its lack of correlation and the investment opportunity, will stimulate some growth in risk transferred in its own right. As the question suggests, there is certainly risk out there currently not being transferred into the market. A lot of this risk is with the U.S. Federal Government, U.S. State governments or Californian homeowners for example, the vast majority of whom don’t have earthquake insurance for their homes.

The new capital can be matched with some of that risk not currently in the market and bring it in. This will be a combination of new capital consciously seeking out that unmet demand and also as the new capital does continue to refinance the peak risks, more risk will be transferred as a result of pricing coming down.

We’re already starting to see a price effect stimulating incremental buying as rates have come down and protection buyers have reinvested savings to buy more cover. We expect that trend to continue.

Sarah: Thank you Adam.

“Last year we saw an annual

issuance of CAT bonds of

approximately $7 billion. . .”

27



Michael Stahel

Partner, LGT Insurance-Linked Strategies, LGT Capital Partners

Sarah Mortimer

Account Director, rein4ce


2.3 INTERVIEW

Sarah Mortimer: What are the

advantages of diversified portfolios

over concentrated portfolios and vice

versa?

Michael Stahel: Insurance-linked securities (ILS) has been in the market for some time already but this year, discussions amongst our client base have really taken off again. We follow suit with other European investors in that we are very much concerned with running a diversified portfolio and not a concentrated portfolio. Whilst you give up some of the returns in comparison with a concentrated portfolio that is heavily geared towards U.S. wind storm, by running a diversified portfolio you are able to equally have European, Australian and Japanese exposures. The benefits are clear in that in running a diversified portfolio the loss potential is much lower than for a concentrated portfolio.

You may give up return potentials but realistically these are minimal at roughly 1 or 2% on an annualised basis and simultaneously you may improve the downside potential by 20% to 30%. This means that instead of running a 95% tail wind minus 40%, you end up running at minus 15% to 20%. We hence strongly advise clients to give up 1% to 2% in short-term annual gain to save on a 20% additional loss potential – in our view the only sensible way to invest in insurance-linked strategies. The approach of U.S. and Bermuda managers is different because they go for more ‘bang for your buck’, as they say, and are heavily geared towards U.S. wind storm risks. 70% to 90% of the

overall ILS allocation would typically be allocated to this peril.

Our clients are typically pension funds who are looking for a diversified allocation within their portfolio and so accordingly allocate between 1% and 3% of total assets to ILS. We typically hear this portion doesn’t need to be diversified because it’s the diversifying bit in the overall asset allocation. We strongly disagree: if you do not diversify that ILS proportion as a pension fund manager, you could be in danger of losing as much as 50% of your ILS allocation with one single US wind storm event. Pension funds must ask themselve if they allocate 2 % to ILS would they want 1% of their overall asset base to be lost in one single wind event? The answer is typically no and as a fund manager we also do not want this within our portfolios.

Sarah: What do you think has

prompted discussion on ILS again?

Michael: The rate environment has come under pressure for two reasons. Firstly, the increased capital flowing into this market from institutional investors which has boosted investor demand and secondly, there haven’t been many severe catastrophes in the last couple of years. 2013 was a quiet year and as a result, there was less demand from capacity buyers which enabled insurance and reinsurance companies to build up their reserves. The pressure that we see on pricing is already having a very strong effect on the U.S. wind rates. The U.S. wind allocation has always had a bit of an opportunistic characteristic but since

pricing has decreased for this region, more investors are starting to really question this U.S. way of investing; the promised excess returns are no longer being generated, yet clients still sit on the higher loss potential. Today, running a concentrated portfolio over a diversified portfolio does not yield much of an excess return anymore and so finally institutional investors are paying attention to the downside risk potential.

Sarah: Have any of your investors

and sponsors been talking about

securitising new diversifiers?

Michael: This is an interesting question. We don’t really believe in new diversifiers but feel that ILS investors should rather focus on the peak regions where the traditional reinsurance market is no longer able to provide the capacity and where counterparty credit risk really matters. We at LGT do not believe ILS investors should engage in “diversifying” risks such as Chilean earthquake. Re-insurance companies are much better suited to provide this capacity as it does not bind much capital and reinsurers can make best use of their balance sheet and apply a leverage factor. However, it is still very much possible to structure diversifiers within the peak regions, e.g. in U.S. windstorm; such transactions would then not cover the big single event, it can be structured as a sideways transaction which addresses multiple events but still focuses on U.S. wind. Such a transaction is not exposed to first event risk and thereby offers an interesting diversification to an ILS portfolio.

28



Sarah: Pension funds are increasingly

seeking to capture the premiums

available for investing in less

liquid assets- how do collateralised

securities support this?

Michael: LGT has a very big franchise on private equity investments and so aside from the fact that we are one of the largest ILS investors we are also one of the largest private equity investors and across both businesses there are similarities. There is an illiquidity premium in investing in collateralised reinsurance transactions; pension funds are looking to capture this illiquidity premium and allocate into less liquid ILS investments, though it has taken time after the financial market crisis to come to terms with such less liquid assets.

Right after the crisis there was a big strive for liquidity and transparency, triggered by the low yield environment. Today, pension funds are seeking to recover that lost yield and are consequently becoming increasingly comfortable with illiquid positions. Whilst collateralised reinsurance contracts are less liquid, it is important to note that they are only illiquid for 12 months. At expiration, the investors get their money back. It’s different from looking at, say, a 10 year allocation of private equity because collateralised reinsurance is a very short-term illiquid instrument that equally brings many upsides. It helps to lower correlation and owed to the short-termed illiquidity, there is no market to market fluctuation around pricing. Pension funds are increasingly looking at this illiquidity as a means of providing even lower correlation and an improved pricing element.

Sarah: How can collateralised

reinsurance contracts enhance the

diversification benefits that CAT

bonds already provide pension funds

with?

Michael: Our most recent analysis shows that the current CAT bond market is heavily geared towards first

event U.S. windstorm. In fact; 73% of all CAT bonds issued today are geared towards U.S. wind. The question therefore is: how can you diversify away from that? Collateralised reinsurance provides such an opportunity because it enables investors to allocate to sideway structures, for example - something you cannot do in the current CAT bond market. You do not see enough CAT bonds in European wind, flood and earthquakes or Japanese wind and earthquakes, and finally even in Australian and New Zealand catastrophes. It is fair to say that in these regions the CAT bond market is not providing sufficient supply. To counter this we use the collateralised markets to source additional risk. It’s important to note that CAT bonds still provide an important foundation but the difference is that today, in a perfect ILS portfolio, CAT bonds form only a third of our portfolio offering, the remaining two-thirds are allocated to collateralised reinsurance with a blend of U.S. wind, sideways, other U.S. natural perils and a strong allocation to European and Australasian perils.

Sarah: Why would you not

advise investors to opt for a pure

collateralised reinsurance approach?

Michael: The answer lies in the liquidity and utilisation of market opportunities. If you tie everything up in illiquid positions you will be unable to make best use of market environments because you won’t be in a position to capitalise on market shifts and other short-termed interesting investment opportunities. Even an investor with a very long-term target may still want to shift the allocation during the year to change the portion of CAT bonds in order to potentially generate liquidity. There will be opportunistic transactions around an event; this

might allow to buy bonds which are under pressure, allocating to new risks or enabling your client to increase or decrease their allocation by up to a third because if the portfolio is one third CAT and two-thirds illiquid then you can sell positions and generate the cash for a shift.

Sarah: Are investors concerned that

this market hasn’t been properly

tested?

Michael: There are several elements here and it can be approached from different angles. From the pension fund manager’s view, the key concern raised is ‘how much money can I lose?’ This is easy to answer because ILS managers can be very transparent with their clients as to how much money they would lose should a severe event such as a CAT 4 or 5 hurricane hit Miami; for example they could risk losing 15% of their allocation.

Protection buyers typically ask how the collateralised markets will react to such a situation and whether the market will be sustainable. We have seen the wall between the capital market and reinsurance market torn down which has subsequently resulted in increased capacity and movement between the capital and reinsurance market. However, if rates drop further, liquidity and capacity will be reduced and pension fund investors will begin to look elsewhere for other opportunities – which is when the market has reached a form of equilibrium.

On the other hand, if an event occurs and rates rise, cash will flow in much

“if you do not diversify that ILS

proportion as a pension fund

manager, you could be in danger

of losing as much as 50%. . .”

29


Diversified vs. concentrated portfolios: exploring a CAT bond and collateralised securities blend

quicker than we have experienced in the past. To a prime insurance company who fears that post event capital market investors will flee I would say actually the opposite will occur as people expect rates to rise. We’ve had discussions with several European pension fund managers who have opened up to ILS as an asset class, have had it approved by their trustee boards but have not yet allocated. Instead, they are waiting on the sideline until the opportune moment, right after a natural catastrophe. They will shift in money so easily that in essence the reinsurance cycle as we’ve known them will become much less pronounced going forward.

We see many investment managers, including ourselves, already lined up with new investment vehicles set up ready to be pulled out of the drawer immediately after an event. On one hand, there is a long lock-up on existing money which prevents money from disappearing and enables us to bring additional capacity right after the event. Going forwards we will increasingly see more strategies that include capital already been committed, but not called up. Investment managers have lined up contractual agreements with pension funds to provide us with money right after an event, enabling us to enact the cash call and commit to signing contracts. In effect, our institutional clients would be saying we’ve had a CAT 3 hurricane hitting Florida, so let’s move in and allocate.

Michael: A last point is around what type of investment manager is best suited to this change in market environment. There is a different skillset required for allocating into collateralised reinsurance as opposed to CAT bonds, and it’s very much driven by the sourcing capability. CAT bonds are offered to you as an investment manager whereas collateralised reinsurance is hard work; you have to go out and source these transactions. We do a lot of travelling and for us location is key, although being based in

Zurich does help when seeking parties to line up potential future transactions with. Going forward, being successful as an insurance-linked investments manager rally comes down to sourcing capability!

Sarah: Thank you Michael for sharing

your insights.

“73% of all CAT bonds issued

today are geared towards U.S.

wind. . .”

30


SECTION 3

Packing life risk into capital markets for maximum indemnity coverageWHITE PAPER

THE EMERGENCE OF LIFE RISK

31


Persistent demand for risk transfer solutions

Life insurance, in the form of mortality protection products and pension and annuity products, is the dominant insurance line in most of the large, developed insurance markets of the world.

The two main risks in life insurance are excess mortality and longevity — both of which centre on the question of life expectancy. While excess mortality is a heavy-tailed event risk, longevity is considered a long-dated, trend-like risk.

It is estimated that if a large pandemic were to occur, claiming several hundreds of thousands of lives in the US and Europe, insurance claims could rise beyond $130bn. Due to the low frequency of such events and the historical profitability of mortality protection products, the potential impact to the life insurance industry appears to be not adequately reflected in life insurers’ hedging strategies. Reinsurance and retrocession capacity is limited leaving life insurance and reinsurance companies largely unprotected in the event of a major pandemic.

An imbalance of exposures and capacity constraints also applies to longevity risk: it is estimated that only a small percentage of the UK’s total longevity exposure (approximately £1.5 trillion) has been reinsured in the traditional (but small) longevity reinsurance market. In a 2012 survey, corporate pension schemes in the UK ranked longevity as their highest risk, ahead of interest rate and inflation risk. Along with buyouts, longevity swaps based on a standardised longevity

index or on an individual portfolio of annuitants, are seen as a preferred tool to isolate and hedge longevity risk. Since 2008, approx. £63 billion of pension liabilities were transferred via swaps and bespoke pension buyin/out arrangements.

The insurance industry is facing extensive capital requirements for their excess mortality and longevity risk exposure. The solvency II standard formulas provide for solvency capital requirements at an annual 1-in-200 year risk level. Possible scenarios circling around that level would comprise a shock mortality event with 1.5 excess deaths per 1’000 or a permanent 15% increase of the baseline mortality rate (Mortality Risk) or a permanent 20% decrease of mortality rates (Longevity Risk).

Increased risk awareness, obvious capacity constraints for life insurance risks and regulatory pressure (Solvency II) all have open up new opportunities for dedicated investors willing to take on exposure to pure life insurance risks. As a result, the transfer of life insurance risk to the capital markets has grown significantly over the last 15 years (in tandem with growth in the non-life catastrophe bond market). Since 2000, approximately $27 billion in life ILS has been placed with capital market investors. Market activity receded with the onset of the financial crisis in 2008 but has recovered since. The outstanding volume of all life related transactions (securities and over-the-counter) is estimated at around $120 billon. The spectrum of transaction comprises pure population index based excess mortality and longevity bonds and swaps; Value in Force securitisations; and structures that provide financing for the excess mortality reserves that are required by the regulators of U.S. life insurance companies.


Marcel Grandi

Head of Life, Credit Suisse Asset Management

WHITE PAPER

Life expectancy improvements for the UK market

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 2016

Mor

talit

y ra

te f

or U

K m

ales

age

50

-90

Source: UK GAD. Last data point: 2012

32



Transaction examples

For an investor, the purest and most transparent method of obtaining exposure to extreme mortality and longevity risk is to invest in transactions based on an underlying mortality or survival rate index that has been constructed using age and gender weighted mortality or survival rates gathered from publicly available data provided by national statistics offices. At maturity (e.g. year 10), the floating-rate payer (investor) will make a one-off floating payment if the realised mortality or survival rate of the relevant cohort has exceeded the specified attachment point. Up until this point, he will have received the fixed leg which is the risk premium. Standardisation of trades and the apparent transparency should help to create a liquid marketplace essential for many investors.

Sponsors, on the other hand, prefer indemnity structures that allow for a perfect hedge with their underlying life portfolios. Certain longevity swap structures allow for such an indemnity protection. Respective transactions are structured as a cash flow hedge with a monthly swap of the actual annuity payments (floating leg) against conservatively modelled best estimate annuity payments anticipating future mortality and life expectancy and including a risk premium (fixed leg). The investor pays the floating leg and receives the fixed leg. To avoid idiosyncratic risk, the portfolio must be sufficiently large (typically >100,000 lives) and balanced with a broad range of similarly-sized individual annuity values. Actual annuity payments can be capped and the realised mortality can be floored in order to limit the downside risk for investors. In order to be able to limit the term of the transaction, it is necessary to determine a commutation procedure based on a pre-agreed formula with pre-agreed mortality assumptions at the commutation date.

Similarly, mortality transactions may be based on the actual claim amount defined as the insured amounts for all insured in the underlying portfolio that died during the respective experience year. Actual to expected mortality may be an additional transaction feature.

Indemnity covers are furthermore already in place with Value in Force (ViF) transactions where the sponsor is monetising the future profit of a life insurance portfolio – an intangible asset. The financing generated through the transaction is being repaid with the future premium earned from the underlying portfolio. The investor will have exposure to the original lapse and mortality risk of the portfolio as a significant reduction of “in force” policies through lapse and mortality affects future profits (premium) necessary to repay the financing.

Looking ahead

There are still diverging ideas about the optimal risk transfer solution between investors and sponsors, with the first preferring out-of-the money structures and clear limitations

on the term whereas the latter favour a closer alignment to the underlying risk with transactions being closer at-risk and with longer maturities. Liquidity concerns still limit the growth of such sponsor-friendly capital market transactions. Nevertheless, modelling agencies have advanced their life modelling tools in order to meet the growing market interest. Ultimately, sponsors hedging and financing needs and an increased understanding of the risk by investors will help to further develop the market.

“transactions are structured as a

cash flow hedge with a monthly

swap of the actual annuity

payments (floating leg). . .”

Credit Suisse’s Insurance Linked Strategies (ILS) team combines more than 170 years of experience from reinsurance, underwriting and risk modelling and has been one of the largest managers in the ILS market for more than a decade. The team today manages a breadth of ILS portfolios on behalf of institutional and private investors including onshore and offshore funds and customized mandates. For more information, contact your Credit Suisse relationship manager or visit our website.

credit-suisse.com/ils

Low correlation, an experienced team, attractive returns, and a diversified approach are the cornerstones of taking the L-E-A-D.

Credit Suisse Insurance Linked Strategies

34


SECTION 4PICKING YOUR DOMICILE

Experience and expertise: a key ingredient for insurance-linked securities domiciles

WHITE PAPER

35


Investors and managers continue to be drawn to the

non-correlated nature of insurance linked securities (ILS)

investments.

It’s not only because ILS products are non-correlated with the general financial markets that they are liked, but the fact that they are also providing good returns at a time when a low interest rate environment remains. Although specialist catastrophe funds remain the largest investor in ILS, mutual funds including pension funds and institutional investors have increased their participation in the asset class significantly.

Aside from investors, insurers like ILS because it enables them to purchase additional protection for low frequency, high severity losses, including natural and non-natural perils, operating in the traditional insurance market, typically in the form of catastrophe (CAT) bonds, collateralised reinsurance or industry loss warrants.

Indeed, the popularity of ILS is borne out in figures from Aon Benfield Securities to the end of last year, which shows that 2013 was a ground-breaking year for the ILS market with a full-year issuance total of $7.5 billion.1 The strong issuance seen in 2013, the second strongest single year on record after 2007, helped the total amount of catastrophe bond limit outstanding jump to $20.3 billion, according to Aon Benfield Securities, the highest level in the market’s history.

Domicile strength

Offshore jurisdictions such as Guernsey, Bermuda and Cayman are at the heart of the growth in the ILS market, while onshore locations including Dublin, Malta and more recently Gibraltar are increasingly looking to the potential of the asset class.

Taking Guernsey as an example, the ‘twin-attractiveness’ of ILS suits it perfectly as the Island has a long track record and existing expertise in both the insurance and investment fund sectors which can be combined and optimised in its ILS offering.

Guernsey, which is ranked as the number one captive insurance domicile in Europe and the fourth largest globally, saw 89 new international insurers being licensed during 20132, a large

proportion of which were vehicles relating specifically to ILS and their use of Protected Cell Companies (PCCs). Guernsey insurance managers Robus and Aon Captive and Insurance Managers (Guernsey) were responsible for approximately 40 of these new additions between them.

In 2013 Robus’ Protected Cell Company (PCC), Hexagon PCC Group, established 22 ILS structures under the Hexagon PCC Group umbrella. These structures are being used to conclude fully collateralised reinsurance contracts (sometimes known as private trades) in the non-life space. These see each cell enter into an excess of loss/aggregate/quota share reinsurance policy for various covers such as property (natural and non-natural perils), marine, energy, crop, premium reinstatement or prize indemnity. The cell is then fully funded by the investing ILS fund up to the amount of its maximum obligation under the reinsurance contract.

Meanwhile, Aon Captive and Insurance Managers (Guernsey) have been involved in more than 80 ILS transactions since 2006, with annual transactions increasing year on year. One of those is Solidum Re Eiger IC Limited, an insurance vehicle which listed bonds with a value of $52,500,000 on the Channel Islands Securities Exchange (CISE). The transaction was a reinsurance placement accepted by an incorporated cell from a US cedent. The transaction utilised a dual listing on the CISE and the Vienna Stock Exchange. It was also the first ever private catastrophe bond listed on any exchange worldwide.

Industry feedback also suggests that a number of collateralised ILS transactions were completed in 2013 which saw International Swaps and Derivatives Association (ISDA) contracts being used as an alternative to a reinsurance contract, demonstrating the breadth of the collateralised reinsurance and ILS business currently being undertaken.

Bespoke ILS

While Bermuda and Cayman arguably remain the most active in the ILS space at present, particularly in the volume of platforms such as CAT bonds issued to retail investors, Guernsey has developed a niche in more bespoke products that are created in conjunction with the investors – both institutional and professional – as well as the managers.


Fiona Le Poidevin

Chief Executive, Guernsey Finance

WHITE PAPER

1. Aon Benfield, Insurance-Linked Securities, Fourth Quarter 2013 Update.

2. Figures available from the Guernsey Financial Services Commission – www.gfsc.gg.

36



An example of this is a structure judged to be one of the Islamic finance deals of the year for 2013 and the top deal in Europe by Islamic Finance News. The structure, the Salam III, Sukuk Wakalah Programme, was devised by Bedell Cristin’s legal team in Guernsey, on behalf of the European insurance group FWU AG. The deal, which was praised for its innovation, was $100 million in size and the first tranche of $20 million closed in October 2013. Bedell Cristin was counsel to the issue and the issuer and worked alongside the European Islamic Investment Bank, Rasmala Group and legal firm Morgan, Lewis and Bockius.

The deal also demonstrated Guernsey’s high-standing in the international funds sector due to the experience which has accumulated over many years in dealing with a broad range of asset classes such as private equity, venture capital, funds of hedge funds, infrastructure, property and now ILS as a standalone asset class. Guernsey provides access to capital markets, most notably the London Stock Exchange (LSE) and other international exchanges including Hong Kong, Toronto, Ireland and Euronext among others, as well as the domestic CISE.

For example, the Guernsey domiciled DCG Iris Fund listed on the Main Market of the LSE in June 2012 after Dexion Capital raised more than £60 million for the vehicle – a closed-ended feeder fund into the Low Volatility Plus Fund managed by Credit Suisse Asset Management’s ILS team. DCG Iris announced in January of this year that it had achieved a total return of 2.2% in the six months to 30 November 2013, helped by low catastrophe losses. The company said it had also boosted returns by shifting away from catastrophe bonds into higher yielding private collateralised reinsurance deals.

Guernsey actually has more entities listed on the LSE markets than any other jurisdiction globally (excluding the UK). LSE data to the end of December 2013 shows that there were 115 Guernsey-incorporated entities listed across the Main Market, the Alternative Investment Market (AIM) and the Specialist Fund Market (SFM)3. Guernsey added 17 new entities during 2013, which again was more than any other jurisdiction except the UK itself.

Sufficient liquidity is a major challenge for many insurance related funds, but Guernsey’s experience in successfully listing vehicles on the LSE and other markets is a key ingredient of its offering, as is the Island’s experience of dual listings. Dual listings bring with them the potential liquidity offered by a secondary market, such as the local CISE, which is a major benefit for an ILS investment strategy.

Regulatory changes

Many onshore domiciles will point towards the anticipated introduction of Solvency II4 in 2016 as a catalyst to greater opportunities for ILS offerings within the European Union. Guernsey and other offshore domiciles are content that current ‘fronting’ arrangements will continue – as had always been the case for these jurisdictions previously. Guernsey, which is not part of the EU and is not obliged to adopt the requirements of EU directives, announced as far back as 2011 that it would not seek equivalence under Solvency II, thus providing certainty to its international client base going forward.

Under the current proposals, Solvency II is set to impose a blanket set of capital requirements and therefore equivalence would burden Guernsey and other offshore insurers with unnecessary additional costs and render currently effective business plans uneconomic. Guernsey’s propositions to comply with the standards laid down by the International Association of Insurance Supervisors (IAIS) and as part of this, it is developing its own solvency regime. This is actually attractive for insurance vehicles currently based within EU domiciles, especially where they are writing business outside Europe and may become increasingly so if the uncertainty regarding Solvency II continues and if the implications for insurance vehicles appear particularly onerous. Guernsey’s decision not to seek equivalence with Solvency II means that it offers ILS structures the certainty of a regime which is proportional, risk-based and free from any potential restrictions set to be imposed by Solvency II.

Offshore domiciles are also in an advantageous position for ILS when it comes to EU legislation such as the Alternative Investment Fund Manager’s Directive (AIFMD). For example, with Guernsey not being in the EU, it is not required to implement AIFMD and is considered a ‘third country’ for the purposes of the Directive. This ability to either stay out or ‘opt in’ to the rules could be of critical importance, particularly for the many ILS funds that are targeted at only non-EU investors.

3. Figures available from the London Stock Exchange - www.londonstockexchange.com.

4. Solvency II – the EU’s proposed regulatory regime designed to impose common capital requirements and risk management standards across the EU.

“2013 was a ground-breaking year

for the ILS market with a full-year

issuance total of $7.5 billion. ”

37


With that in mind, Guernsey has introduced a dual regulatory regime for investment funds, which sees Guernsey’s existing long-standing flexible regulatory regime remain in place for those investors and managers not requiring an AIFMD compliant fund, including those that avail of EU National Private Placement (NPP) regimes and those who market to non-EU investors; and there is a new opt-in regime which offers full AIFMD equivalence – for those for whom it is necessary or otherwise desirable to have an AIFMD compliant fund vehicle to take to market.

ILS managers and funds with no connection to the EU should continue to use Guernsey’s existing flexible regulatory regime which is completely free from the requirements of AIFMD and as such, will have significant operational and cost benefits. As a third country, Guernsey-based managers and funds who want to access Europe continue to use NPP regimes, which are expected to remain until 20185. The NPP route will likely be favoured by many given that the requirements to satisfy AIFMD will be significantly over and beyond what is required under NPP.

Guernsey has an existing base of clients for whom Europe is at least a very important market and the opt-in equivalent regime which has been in place since 2 January 2014 will be appropriate and appealing to such funds. It is for this reason Guernsey enacted the equivalent rules ahead of when they were actually required to do so. Full passporting for non-EU AIFMs is expected from July 2015 and Guernsey managers will be ideally placed to market on a pan-European basis with a single authorisation, as passporting is currently envisaged to operate.

Conclusion

Guernsey’s funds regime is just one of a number of outstanding factors that means the Island provides a unique proposition as an offshore hub for ILS business. Recent statistics suggest this is now being recognised by many in the market itself and as the demand for ILS funds continues, as is anticipated if pricing

remains attractive, then it is likely that Guernsey’s reputation for its special-purpose insurers, cat bonds and transformer structures, will become a key ingredient in its success moving forward.

Fiona Le Poidevin is Chief Executive of Guernsey Finance,

the promotional agency for the Island’s finance industry.

Address: PO Box 655, North Plantation, St Peter Port, Guernsey, GY1 3PN Phone: +44 (0) 1481 720071 Fax: +44 (0) 1481 720091 Email: [email protected] Web: www.guernseyfinance.com


“Guernsey has developed a niche

in more bespoke products that

are created in conjunction with

the investors.”

5. Guernsey has signed 27 cooperation agreements with the securities regulators from the following EU/EEA countries: Austria; Belgium; Bulgaria; Cyprus; Czech

Republic; Denmark; Estonia; France; Finland; Germany; Greece; Hungary; Iceland; Ireland; Latvia; Liechtenstein; Lithuania; Luxembourg; Malta; Norway; Poland;

Portugal; Romania; Slovak Republic; Sweden; The Netherlands; and United Kingdom.

If you’re looking for an innovative financial solution there’s one place you should look...

Guernsey combines 50 years’ financial heritage with a modern, well regulated infrastructure.

The result is an international financial centre with the pedigree, experience and expertise to meet even the most exacting of needs, be they across banking, investment funds, private wealth or insurance.

Add to this our reputation for innovation and a broad range of service providers, including a full set of support services and you can see why Guernsey offers an ideal location for your business.

Make Guernsey your first port of call.

Telephone: +44 (0) 1481 720071 Email: [email protected]

guernseyfinance.com

here.

BANKING FUNDS INSURANCE PRIVATE WEALTH

39


SECTION 5




5.2 ROUNDTABLE

5.3 INTERVIEW

5.1 INTERVIEW

THE LONG-TERM HORIZON

40



Steve Evans


Tony Rettino

Founding Principal and Portfolio Manager, Elementum Advisors


5.1 INTERVIEW

Steve Evans: What would you say to

those questioning the sustainability

of insurance-linked securities (ILS)

instruments and how will you

respond if 2014 proves less benign

than previous years?

Tony Rettino: There are 2 questions here: the first being can they, the second will they? Most of our investors are large institutions committing less than 2% of their assets to reinsurance. If they were to lose 40% of the capital that they committed, it’s a bad month; whereas, if a reinsurer loses 40% of its capital, the reinsurer is likely to lose its rating. The institutional investors that form our capital base can therefore afford to be more concentrated because they are in a much better position to both sustain large losses and to have the financial resources to recapitalise after that loss.

The more interesting and complex question is: will they recapitalise? This is what I see as the central point in the sustainable market question. While clearly some investors in today’s market environment are more temporary, owing to low interest rates and low credit spreads, we anticipate that most large institutional investors will return to the market. The reason being that they spend an enormous amount of time (up to 2 years) performing the appropriate due diligence before investing and have a history of re-investing in this and other asset classes. An interesting point about our model, relative to a traditional reinsurance model, is that we speak with each of our investors at least semi-annually and provide extensive details as to the risks in the portfolio. We are a lot closer to our investors and have a strong

intuition as to their sustainability following a loss and manage expectations ahead of one.

The next question is, of course, what could change in the above? To have a stable market, the market has to collectively ask itself, “just because you can, should you?”. The question for us managers is whether or not we should take on more capital just because we can. For example, should I take that extra $200-300 million that may be put to work in more marginal types of investments? As a privately held firm, we are cautious and look to match capital with opportunities to deploy it; and last year, we actually turned away certain capital. Any new capital has tended to be from new market entrants who are starting with a very small proportion of what they ultimately plan to invest in the long-term.

For both investment managers and reinsurers, one question that needs to be asked is whether we are providing the proper level of transparency to our capital providers. When you think about sustainability, a surprise small loss is worse than an expected big loss. If we, or the reinsurers running sidecars, have not been fully transparent with our investors collectively, then capital may not return and credibility may be questioned. Some of the sidecars cover business that reinsurers don’t typically write or keep, which, from our perspective, could create some difficulties following a loss event. We have also seen some disruption in the catastrophe (CAT) bond market over time as a result of structural issues, including the more aggressive collateral structures in the years leading up to the financial crisis.

For brokers and insurers, the question is: just because I can reduce disclosure or push terms and conditions through in order to expand coverage and include un-modelled or poorly modelled perils, is this the right way to build long-term relationships?

There is a lot of discussion about relationships in this market. We work with our insurance clients to devise the right level of pricing and structure that works for us both over the long-term. That creates a more sustainable model. It’s very clear that the large price increases put on insurance companies following past major losses has opened the door for alternative capital. The point to take from all this is that just because you can use leverage, you shouldn’t automatically do so.

Steve: Do you think traditional

reinsurers who aren’t leveraging

third party capital may have seen the

end of goodwill price increases after

events?

Tony: It will be path dependent. There are brokers and insurance companies really pushing the envelope. I’ve been in this market since 1994 and would add that those who ‘push the envelope’ in the soft market pay for it on the back end, whereas those who adopt a longer-term perspective reach more sustainable returns. I would gladly trade the excess returns of the peaks for higher troughs and, in particular, less deterioration of terms and conditions. Such a trade-off is one which I feel both our investors and our insurance clients would welcome. Twenty-five years ago all CAT losses were funded by equity on insurance and reinsurance company balance

41


sheets. Today approximately 15%, or in peak regions around 25%, of losses are funded by flexible capital structures; these are funds such as ours and sidecar vehicles. This has helped create a more flexible capital structure, which in turn reduces volatility and should benefit all parties going forwards.

Steve: New market entrants have

pushed spreads and risks down; what

impact has this had on the traditional

reinsurance model’s flexibility?

Tony: There’s been a lot of healthy convergence and innovation. The ability and willingness of reinsurers to provide more multi-year capacity and aggregate type structures is a good thing. Other mechanisms from the CAT bond market, such as the way premiums or layers are adjusted within or across years, are making their way into reinsurance, as are cascading limit structures. Likewise, many good elements from the reinsurance market are making their way into the capital markets, including more indemnity and reinstatable coverage. And let’s not forget, proper alignment of interest, the loss of which we believe contributed to the financial crisis, has been a hallmark of the reinsurance market for centuries. The end result of all of this is better and more flexible solutions for reinsurance buyers.

Sidecars and third party funds have provided reinsurers with more flexibility in their capital structure. This, however, comes with some serious potential conflicts of interest, which some deal with very well, while others do not. It’s going to be an interesting question as to whether or not the investors involved in those vehicles feel, post-loss, that the risks were fully disclosed. It’s a tricky situation to balance and it remains to be seen how this will evolve.

Steve: Capital markets are charged

with leading the way on loss and

damages, what considerations do you

subsequently have for your long-term

ILS model?

Tony: In evaluating new risks, we first have to consider what the long-term value proposition is for our investors and how well can we understand and quantify that risk. Much time is spent considering the amount of risk currently being transferred in the market and the related excess capital because there is a clear opportunity for growth on the horizon. That said, not much time has been spent drilling down into where these growth opportunities will come from. Between 1980 to 2013 there was $3.8 trillion of losses, 70% of which was uninsured- it’s a big hole. For me, the real question is who will ultimately fund these losses.

In emerging markets, we first need a developed insurance market and improved data/modelling for a reinsurance market to truly develop, but it’s fair to say that there’s a lot of additional capital that can be brought to bear. We see more immediate potential for the capital markets to absorb uninsured risks in the U.S. If you look at wind pools, the potential (and need for) higher take-up rates in California for earthquake risk and the potential privatisation of flood risk, it becomes clear that there is a lot of risk that can very easily be absorbed into our existing ILS model. Over time, this growth will be echoed by the developing markets, with China most likely leading the way.

Steve: Is an ILS and traditional

reinsurance blend the only strategy

for creating a sustainable model

hedging against systemic risks? If

not, what other strategic options are

there?

Tony: There is not a one size fits all model that’s right for everyone. In general, I think a combination of ILS and traditional reinsurance creates the most value for our insurance company clients. Elementum is not a hedge fund or a reinsurer but an alternative investment manager focused on property catastrophe risk. One of the fundamental components being that we’re indifferent to the

form of instrument providing the risk transfer, whether it’s equity, debt, CAT bond, private CAT bond, collateralised reinsurance or exchange traded derivatives. To our clients we simply stress that we aim to bring capital to risks through a variety of innovative solutions. Any inefficiencies are in silos, but that will ultimately change. Those successful in the market will be indifferent to form, whereas those that struggle will be the ones sitting on a single box solution. There is limited equity, hybrid equity or debt type solutions but of course this can and will change. The sidecar is a hybrid capital instrument that, if done correctly, offers real market development.

Steve: Where do you see Elementum

in 5 years’ time? Do you see your

current focus on property changing?

Tony: We believe that a focus on our core expertise is paramount and, for the foreseeable future, there’s enough runway in property catastrophe risk to provide value for both investors and clients. Markets such as marine and aviation are tiny, and there isn’t a crying need for capital. Reinsurers can provide that off of a levered balance sheet with much more efficiency than we can. The value proposition has to be there for it to make sense for our investors and insurance company clients. There’s all sorts of horror stories regarding style drift, which is why I’m cautious of who is writing a line of business just to cede it out to capital markets. Our focus is on product development and innovation. So, in the intermediate term, our efforts will be on new structures and forms of capital and finding ways to bring more risk into the private market (such as earthquake risk and risk from wind pools) and exploring other areas of growth such as U.S. flood and risks coming from emerging markets.

Steve: Thank you Tony.


Elementum Advisors, LLC

For more information, contact:Elementum Advisors, LLC225 W. Wacker Drive, Suite 2160Chicago, Illinois 60606

+1 (312) 281 [email protected]

43



Steve Evans


John Whiley

Head of ILS Administration, SS&C GlobeOp

Daniel Ineichen

ILS Portfolio Manager, Schroder Investment Management

Stephen Rooney

Partner, Mayer Brown

Panellists

Moderator

5.2 ROUNDTABLE

Steve Evans: The insurance-linked

securities (ILS) marketplace has

evolved to sufficient size to now

be considered durable, robust and

investable but in doing so what

operational challenges has this

created?

John Whiley: At SS&C GlobeOp, we provide ILS administration services to fund structures and sidecars that require institutional investor reporting. Whether we work with an independent manager investing in the asset class, a hedge fund sponsored ILS manager, or a reinsurer supported ILS manager, the challenges remain the same. Getting the rules of the game correct from inception is essential so the ILS Manager can articulate why a particular option represents the best alternative for their investors. These rules relate to how the launch capital will be invested into the structure and how the structure will provide liquidity to the investor, especially when there are loss impacted contracts. For launch capital, what we see today, are subscriptions being processed on a commitment basis to ensure there is ‘just in time’ capital rather than excess cash being left on the balance sheet creating a return “drag”. Typically there’s a ramp up phase when dealing with an illiquid asset that requires the subscription flow to deploy over a six month period, unless there is a quota share of an existing book of business.

Traditional open ended fund mechanisms for restricting liquidity such as lock-up periods and gates generally do not work well in the ILS fund context. This has led to the use of redemption shares or slow pay shares to manage liquidity on a redemption basis and enable investors to exit the structures. Redemptions may take between six and twelve months on the liquidity side, whereas a pension investor working with a traditional reinsurer can take years to exit.

Given there is often performance-based compensation paid by the investor to the ILS Manager, our job as an independent administrator is to ensure the rules of the game are followed and adhered to throughout the investment term with experienced people and processes, whilst providing transparent reporting.

Daniel Ineichen: Firstly I would like to make a distinction between the tradable market, catastrophe (CAT) bonds, and other types of insurance risk. Main challenges are also with regard to are increased regulatory requirements and general pricing policies that we have to adhere to under the diverse regulatory schemes. Challenges are definitely larger on products that invest in private transactions and here the liquidity management is a main topic as investors roll a contract into a new

one. Collateral management is a big focus that has come under increased attention and equally so has the discipline within the reinsurance industry to adhere to more timely information requirements that we, as fund managers, usually face compared to the traditional reinsurance market.

We have had to extensively educate investors on how it works and also reinsurance counterparties on what our needs are. The last point to make is definitely around the validation of those private transactions where we have put a lot of effort in. If the market evolves to become even more robust and bigger we need to have a very sound valuation regime for all different types of transactions in place. To achieve this we created for instance processes bringing in independent views for the valuation of our policies.

Stephen Rooney: It’s interesting that both Daniel and John have touched on transparency and liquidity. As this market has grown it’s interesting to observe the number of sponsors who are accessing the market through a 144A, relatively liquid format in the form of a CAT bond, versus a private placement instrument. There have been offerings of participating notes in sidecar vehicles as well as various kinds of equity interests in sidecars or dedicated vehicles.

44



There’s a range of instruments, with differing liquidity profiles, which investors can explore. Over the last year and a half the market has expanded significantly with a lot of innovation and choice. Even within the more conventional CAT bond market there has been a lot of variation, with many more indemnity triggers, including an increasing number of aggregate indemnity triggers. These imply that there is a greater need for real time disclosure to investors with regards to the losses that count towards the aggregate trigger.

We’re also seeing companies attempting to access the market quickly and in doing so are deciding not to have ratings or are running limited kinds of risk analysis. This means that even within the conventional CAT bond there are several differences emerging amongst the transactions. As the market grows it’s important that investors can distinguish and understand what’s being offered; it’s a challenge on all sides of the transaction to structure it in a way that is understandable and transparent whereby the market can assess and properly price the risk.

Steve: The absence of yield in other

asset classes is pulling ILS instruments

away from the ‘alternative’ bucket

towards mainstream investment

tools. What challenges and

opportunities is this likely to create

for investment managers?

Daniel: We definitely observe this shift and in particular for the 144A bond part, allocations have moved out of the alternative bucket and are increasingly coming from the fixed income side which of course, creates different challenges. We speak to clients in a different language and so in many respects it is a translation exercise from the reinsurance language into more natural financial market language.

As the degree of education from our own clients has increased so has the need for transparency because

different investors approach the sector differently and therefore need that transparency in order to understand where the risks have evolved from. For example, on the 2nd April there was a strong earthquake in Chile. As the general response to disasters such as this has quickened so have incoming investor queries and it is fair to say that the communication we have to have with our investors has increased also. We have to find a line on how we communicate in a trustworthy manner with reasonable, accurate information rather than just issuing a blanket statement.

From a trading side I welcome the new breed of investors who have brought additional liquidity into the market as a result of increased sell and buy motivations, different to the buy and hold dominated players prevailing a few years ago. Now there is much more activity around reallocating portfolios which has subsequently led to another level of liquidity in the tradable market. We have also observed a shift in relative values from market segments because some investors are playing only in the liquid space as opposed to others that access the entire ILS market. As a manager we consider it to be more and more important to facilitating the entire ILS capital market. There are different and significant shifts in terms of relative value between the segments, much more accentuated than say 3 or 5 years ago.

John: I would give it a deeper context. Pension assets are worth around US$30 trillion globally, while hedge fund assets are expected to top US$3 trillion in 2014. This is in comparison with the traditional property reinsurance limit of approximately US$300 billion and an ILS asset class that stood at US$50 billion, with approximately US$20 billion of that in CAT bonds at the end

of 2013. A recent research report issued by Barclays Capital indicated that the ILS asset class could reach US$100 billion in the next few years.

Evidently it’s clear investors are attracted to the ILS asset class because of the returns, diversification and low correlation to equity and traditional bond markets. But this has had an impact on the underwriting cycle where the property catastrophe renewals in the traditional reinsurance market were reported to be down between 15 to 20% in January 2014 and by 20% in the ILS market, with CAT bond yields being compressed by more than 30% since 1 January 2013.

With a decrease in the return profile as the demand for ILS slowly exceeds the reinsurance market’s capacity to offer this asset class; ultimately, the return on investment will be lower for all market participants. It’s going to change some of the rules of the game. Managers will increasingly work harder for less, with lower performance based compensation given lower returns. ILS managers are managing investments that pay on insurance losses. I anticipate those losses will develop the market, as they did in 2011, but equally, will attract new investors as the return profile improves following loss events. This will then likely lead to Pension investors deploying capital that has been sitting on the sidelines.

Stephen: I’ll add one comment but am interested to hear others’ reactions. Market participants discuss what impact the next very big event will have on this marketplace and whether investors, who have been attracted

“There’s a range of instruments,

with differing liquidity profiles,

which investors can explore.”

45



to the asset class because of the yield considerations and lack of correlation, will react adversely to significant losses. Under the traditional insurance market dynamics if the market experienced losses it was an opportunity for those who survived the catastrophe to increase their premium rates. However now, the industry is asking whether that dynamic will hold; assuming of course that there is a continuation of capital attracted to the market and that investors will be willing to double down. There are certainly questions as to how the influx of new capital will impact normal pricing dynamics following a big event.

Daniel: The market has grown significantly but has not really been tested since it has done so. In my experience from the past, pension schemes that started entering the market early and made allocations in the past, have rarely ‘run for the door’ post a big event. They take a long lead time to ensure that they understand what they are buying and often allow for increasing their allocation in a second step in order to benefit from the more attractive yield environment post catastrophes.

In the past, the introduction of cat models has lowered the volatility of the pricing cycle in the reinsurance industry. If capital markets now step in more aggressively post a catastrophe and provide the necessary back-up capital then the pricing cycle’s volatility may be further smoothed. Nevertheless it will remain a cyclical market because risk capital comes and goes; that’s how the market works and it will continue to do so.

The main issue is really around how some investors in the liquid space will react. With medium type catastrophes, like Hurricane Sandy, people tend to stay very calm and disciplined

but with bigger ones they might pull the trigger more quickly. There may well be trading opportunities post catastrophes and the key to success is around the ability to structure products so that they can both survive and benefit from any dislocating event.

John: The pension and hedge fund investors we meet with understand the asset class and that capital is invested to cover potential losses. They also understand the return opportunity following a loss event. The investment being made is more efficient than traditional reinsurance because it allows institutional investors to enter and exit in accordance with the governing documents of the structure. A number of these investors have been around the asset class along time and have been invested with asset managers with proven track records during loss impacted years. We have been working with an ILS manager since 2002. Managers with performance records dating back 10+ years are building benchmark returns for the pension investors to consider. I believe the next significant event will provide a snap-shot in time for investors to compare manager performance records allowing for new capital commitments to be deployed, further developing the ILS asset class to the $100 billion threshold.

Steve: How can pension schemes,

traditional reinsurers and ILS

providers ensure that they are legally

compliant when operating across

multiple jurisdictions?

Stephen: The simple answer is to get experienced legal advice and structure deals accordingly. Generally speaking

there is relative clarity in insurance regulation which has helped the market to develop. Obviously Bermuda, the Cayman Islands and Ireland have been the primary domiciles for the vehicles that actually assume the risk and their regulatory regimes have been clear and relatively user friendly. There is an ever changing regulatory landscape in both the U.S. and in Europe, however, which has required sponsors and investors to adapt and refine their structures in order to remain compliant. There are insurance rules around collateral arrangements and complicated tax laws in both the U.S. and in Europe that need to be addressed.

To date structures have been able to deal with these regulations but going forward there is always the risk that these laws could change and the required transaction structures will have to adapt. The advent of the Dodd-Frank Act and similar complimentary regulations in Europe around regulating derivatives has made life interesting for lawyers in this area, particularly as some of those regulations are continuing to evolve. This has impacted on transaction structures and has served as one of reasons as to why we are seeing more transactions being structured on an indemnity triggered basis.

John: To pick up on Stephen’s comment I would stress the importance of hiring quality service providers including lawyers, auditors and ILS service providers. Ensure that they’ve got a deep bench of talented staff with experience on a variety of ILS transactions and structures. Bermuda has been evolving in this asset class which has been providing a reinsurance return to institutional investors for 20 years. For Bermuda it comes down to having a proactive and welcoming government, regulator and an experienced professional services sector who have supported innovation around the reinsurance and alternative investment asset class.

“there is a greater need for real

time disclosure to investors”

46



New CAT bonds will continue to be structured and listed on the Bermuda stock exchange, new side-cars will be created to cede risk from Bermuda reinsurers, and new Bermuda fund structures will be formed to invest in these securities. In doing so, it brings new and existing investors to the island. If you’re a Bermuda reinsurer transferring risk to one of these vehicles, it makes sense to have the company formed in the same jurisdiction, dealing with the same regulator and governance requirements. It’s a lot easier to manage and navigate when you have the professional service providers focused within one jurisdiction rather than having to manage across multiple jurisdictions.

Daniel: The insurance market is developing continuously on the regulatory side, particularly for the insurance industry’s capital markets. It has definitely been a challenging development and it is of clear advantage to have both global service providers and operations in the right jurisdiction. Moreover, what is valid today may not be appropriate tomorrow and therefore, it is important to keep in constant dialogue with regulators and have the right in-house capabilities.

Steve: Given that it is a more

complicated and unusual marketplace

what additional analysis and due

diligence should pension schemes

seeking, or extending, exposure

introduce?

Daniel: It definitely is complicated and we see due diligence requirements evolving extensively, even though pension schemes are very advanced in their governance. We always urge investors to understand how risks are structured, what the real exposure of a certain product is and how this exposure is managed; particularly in relation to tail risk. I always urge clients and potential clients to determine their objectives and what their risk appetite is for a particular strategy.

We also encourage them to assess the operational set up of a manager because this is where the regulatory question feeds directly in. It is crucial that an ILS manager has very sound operations and clear processes that include the risk providers. Given that ILS allocation tends to be smaller, we often observe the due diligence to be outsourced to specialised boutiques. Given the complexity of the asset class we believe this is a very wise move.

Stephen: Diligence is extremely important in this marketplace. This is an asset class that is very complicated and as I was saying earlier, even those 144A relatively liquid CAT bonds being offered today, have significant differences amongst them. There are refinements constantly being introduced to structures from variable reset provisions, extension provisions, provisions on reduced interest and collateral provisions that are quite nuanced. Given this, investors need to pay close attention and look carefully at the disclosure document and analyse the risk.

The transaction complexity has increased so has the level of transparency. There’s a lot of diligence to do for any institutional investor in these transactions and as you move into the more illiquid transactions the level of transparency differs and the diligence burden increases. It’s an interesting and challenging market for anybody who is putting their money to work here.

John: Ultimately due diligence groups and institutional investors are becoming more educated on the asset class and the governance expectations around key administrative processes, calculations and functions. The historic ‘tick the box’ on service providers is a thing of the past

and instead there is a more rigorous operational due diligence process today whereby sophisticated investors are now asking ‘how do you do this?’ and wanting to see evidence of that process in place.

The inherent conflict of interest between investors and managers, who are often paid based upon investment performance driven by unrealised gains, has led both investors and regulators to mandate the adoption of independent service providers to the alternative investment industry. The trends we have observed at SS&C GlobeOp equally apply to the ILS asset class and include a 30% increase in due diligence meetings with investors, as well as a significant increase in the sophistication of questions posed during meetings. The review of the operating processes to ensure cash payment controls are in place; segregation of duties exist between the trustee, manager and administrator; asset verification and review of valuation policies; and transparency reporting are key. The need for experienced independent service providers with global operations who fulfils all aspects of the due diligence process is an absolute must as the industry moves forward.

Steve: Thank you all for sharing your

views.

“the ILS asset class could reach

US$100 billion in the next

few years.”

John Whiley, SS&C GlobeOp

(441) 295 0329 | [email protected]

H s, Inc.Holdingsologies HC Techno14 SS&C© 20

Prime Management Limited is now SS&C GlobeOp Talk to SS&C GlobeOp about its world-class insurance linked security administration solutions

www.sscglobeop.com

48



Jessica McGhie


Vincent Prabis

Head of ILS Strategies, SCOR Global Investments


5.3 INTERVIEW

Jessica McGhie: How does SCOR

Global Investments’ risk appetite

differs from the insurance-linked

securities (ILS) pioneers and what

benefits can this bring to the end

investor looking for diversified,

uncorrelated returns?

Vincent Prabis: As a traditional reinsurance company SCOR understands the ILS market very well as it has been an issuer of catastrophe (CAT) bonds since 1999, and in addition, has issued a sidecar last year and has been buying fully collateralised retrocession for its own coverage for many years as well.

SCOR wanted to offer investors access to the space under its own brand name. We wanted to take a different approach than the ILS pioneers who only had CAT bonds at their disposal during the initial phase of development of the ILS space from around 2001/2002 until about 5 years ago. At that time, investors often accepted a high concentration of risk in the peak peril/regions. As a traditional reinsurer and sponsor of an ILS fund, this is what SCOR wanted to avoid and so it had to wait for the space to deepen and for other products to become available until funds could be launched.

Over the last 5 years, specific mechanisms allowing funds to access other contracts such as industry loss warranties and reinsurance and retrocession contracts on a collateralised basis have become available. Only once these were available were SCOR able to create

portfolios that were diversified and this is what we have been doing since 2011.

What differentiates us from the ILS pioneers is that, like a traditional reinsurance company, we always aim to have a portfolio as diversified as possible and do not feel that an investor’s diversification in other uncorrelated asset classes is enough. As we emulate the DNA of a reinsurance company, diversification is offered across all funds. Certainly we offer different risk appetites and different liquidity options, but across all funds, we always keep a diversified approach.

Jessica: Although you have different

risk appetites is it fair to say that your

product is better suited to the more

cautious investors?

Vincent: Certainly, and I would add that we are looking for partners rather than investors. As a reinsurance company, when presenting the asset class to potential partners, we clearly explain to them the inner working of the space and in particular its cyclical nature. We insist on the fact that there will be natural catastrophes which will generate draw-downs in the portfolios and describe the ensuing hard market. In doing so, we make sure that we align ourselves with like-minded investors, and ensure that their investment horizon is adequate for the space. For ILS we are talking about a mid to long-term time horizon of 5 to 6 years depending on the strategy. It is vital that they understand that to benefit from this asset class, they will need to be invested throughout the entire cycle.

Jessica: How do you structure your

portfolios accordingly and how

conservative would you describe

them to be?

Vincent: I wouldn’t use the word conservative as ultimately we are risk takers. However, we are conservative with respect to the diversification of the portfolios and the fairly high investment constraints imposed on them. Our everyday job is to ensure that every deal is well remunerated on a standalone basis and that the portfolio we construct is diversified enough. We are not reinventing the space and if we have to participate in the CAT bond market itself, any diversification will remain very much geographical. To find additional diversification, we participate significantly in aggregate contracts, and in second and third events cover that provide added differentiation to a pure “per-occurrence” portfolio. Certainly I wouldn’t describe our strategies as conservative but it’s fair to say that we are more conservative than other participants in the space.

Jessica: What practical advantages

in terms of regulatory compliance,

geographical reach and risk

management can you deliver?

Vincent: As a SCOR sponsored ILS fund we obviously benefit from the reputation of a large Continental European institutional reinsurer, but we also benefit from its infrastructure. Our risk management is completely independent, as well as the internal compliance function, as SCOR Global Investments is regulated by the AMF

49



(Autorité des Marchés Financiers), the French regulator. Practically, we are an onshore asset manager, which is important for many of the investors we meet that are not always comfortable with the fact that our industry, insurance and reinsurance as a whole, tends to be offshore in places like Bermuda or the Cayman Islands. It’s been reassuring for our partners to know that they have met with a publicly listed, large Continental European reinsurance company.

That said, we are completely separate from the underwriting team of SCOR and don’t benefit from their analyses nor have access to their tools. We don’t know what they see, what they quote and ultimately what their portfolio actually looks like. To some extent we are a competing form of capacity. Nevertheless we are able to leverage their CAT modelling tools. We have access through service level agreements within the company to all of the CAT modelling tools that SCOR is using and also to their legal team.

Jessica: Jumping back to the risk

management side, is that a very

blanket approach or can it be

varied and tailored according to the

different investors you’re working

with?

Vincent: We currently manage 4 funds, and only one is a managed account. In that case we have tailored our strategy according to the needs of this unique partner. As we are a publically traded company we are very comfortable providing full transparency on the portfolio we created for them. In general, we are quite happy to talk with investors and develop strategies that will meet their liquidity constraints and target yield as long as they understand the nature of the underlying asset class.

Jessica: You touched on how SCOR

Global Investments sits within its

reinsurance holding company but

have you anything to add on how

you work with the wider company to

appropriately source and market your

offering?

Vincent: When we source business, we do so as an independent team. We have been greatly helped by the broking community over the last couple of years as a result of being sponsored by SCOR. These organisations know the importance of our funds to the senior management of SCOR and have been an important help to our development. The fact that we are offering ILS capacity with the SCOR logo means a lot in the long-term for cedants, especially over new, unknown to the market, capital capacity providers. Brokers do understand this, that well.

Jessica: Do you plan to expand the ILS

instruments you offer?

Vincent: Given that portfolio diversification is so important to us, when we find well remunerated deals on a standalone basis, we are always looking to offer access to more lines of businesses. When we developed our initial strategies, we didn’t limit ourselves to CAT bonds but of course, the obvious limitation for us is the short tail nature of the contracts we can enter into. I hope that going forward we will be able to increase our access to those other areas, but for the time being we’re probably going to need to stay focussed on the CAT business.

Jessica: Of the ILS instruments

presently out there, which ones

capture your attention the most in

terms of aiding the market’s future

long growth?

Vincent: Each instrument has its own advantages and inconveniences and therefore, it’s important to participate on all segments. The market tends to favour CAT bonds

because they provide the liquidity sometimes needed in the portfolio. However, here at SCOR Global Investments we don’t favour one particular product and will continue to pick and choose from the market as it develops.

Jessica: Thank you Vincent.

“As we emulate the DNA of

a reinsurance company,

diversification is offered across

all funds. . .”

51


SECTION 6




6.2 ROUNDTABLE

6.3 INTERVIEW

6.1 INTERVIEW

INTERPRETING AND QUALIFYING RISKS

52



Jessica McGhie


Niklaus Hilti

Head of Insurance-Linked Securities Strategies, Credit Suisse Asset Management


6.1 INTERVIEW

Jessica McGhie: In a diversified

portfolio with single insurance-linked

positions what level of risk should

asset owners expect in their fixed

income instruments and derivative

transactions?

Niklaus Hilti: It strongly depends on the risk appetite and diversification of the investor. It’s fair to assume that most investors tapping into the insurance-linked strategies (ILS) space are already quite diversified on the more traditional side of investments. However, there are two schools of thought on how much risk an investor should take. The first argues that because an investor is already diversified when entering the ILS marketplace they are able to take on a significant concentration risk within their ILS allocation.

The second argues that whilst adding an ILS allocation diversifies the portfolio, if the investor wants to maximise that allocation and its low correlated portfolio position, they will be limited on the amount of risk that they can take. In such instances investors want a more diversified strategy rather than a concentrated strategy.

Jessica: Does that risk depend on the

other assets within their portfolio or

are there other factors that influence

it?

Niklaus: ILS is usually considered as an independent asset class, not comparable to other assets. Moreover, because of this general assumption that ILS has low correlation with other asset classes, the risk question typically becomes a function of how

much they wish to allocate and what their target returns are. Some investors have very ambitious target returns and therefore are prepared to take on higher risk. They typically go for a concentrated ILS product whilst investors, who are happy with a 4% or 5% return, tend to opt for a more diversified ILS investment approach. For them it is important that while achieving this target return they are equally maximising their position of low correlated investments. This is very hard to achieve and ILS are one of the very few asset classes that are able to do so.

Jessica: Do you think asset owners

struggle to accurately compare

premiums of different ILS instruments

and their risks?

Niklaus: The main problem is that investors, and consultants, tend to compare premiums rather than the risk adjusted margins. They simply look at the yield even though this is very dangerous, particularly in ILS. Even in a softening market you can achieve stable premium income by taking on more risk. The question is therefore how much risk you are taking on with the specific instrument. And these risks, unfortunately, are more complex and difficult to understand for many “traditional” investors/consultants as they significantly differ from say, typical equity risks. ILS risks are usually low frequency and high severity event risks; this means that you can easily have 10 years of excellent premium returns but in the 11th year lose everything. As an investor or consultant this isn’t easy to see because typically they don’t put enough emphasis on analysing how much concentration

risk there is within ILS. ILS returns mostly look great if there are no big catastrophes; so simply comparing yields or premiums without taking into account the underlying risk that investors are taking on is dangerous.

Jessica: What steps would you advise

asset owners take to ensure a truly

comparative study?

Niklaus: It is about asking for high transparency and meaningful risk information to ensure that the investor, consultant or analyst can really see how much concentration and downside risk there is. It’s always hidden in the product or strategy and so, of course, getting that transparency with meaningful figures is key.

Jessica: Do asset owners struggle to

get the right level of data and the

right transparency? Is there still quite

a lot of work to be done within that

area?

Niklaus: The ILS space is generally a bit more transparent than the reinsurance space as whole. However, there is a lot transparency in less meaningful information yet consequently investors are not seeing what the downside is, how much concentration risk they are running and how much they could lose in specific scenarios.

Jessica: Should the risks be assessed

separate to the premiums or in

conjunction with each other?

Niklaus: It’s always in conjunction with each. You can always achieve a certain premium in reinsurance and therefore, the important question is around what your risk adjusted margin is. Obviously

53



the combination of premium and risk helps you identify the risk adjusted return or margin, that’s key.

Jessica: Which ILS instruments are

presently delivering the best risk-

adjusted returns and enhancing asset

owners’ strategic objectives?

Niklaus: Historically catastrophe (CAT) bonds have delivered an excess risk adjusted return but since 2013 all ILS instruments have pretty much converged. At the moment I would say instruments like private transactions are slightly better given that there is a higher entry barrier for additional capital than in the CAT bond market. All of the market’s participants are aware of the different instruments and subsequently are much more efficient in using those instruments. Going forward though pricing will be pretty tight because this increased market efficiency is here to stay; there’s more information and more people looking.

Jessica: Thank you Niklaus.

“investors, who are happy with

4 or 5% return, tend to opt for a

more diversified ILS investment

approach. . .”

54



Steve Evans


Elizabeth Garner

Head of Pensions and Investment, Save the Children

Jens Hagendorff

Professor of Finance, The University of Edinburgh

Adam Beatty


Panellists

Moderator

6.2 ROUNDTABLE

Steve Evans: What liquidity, volatility

and performance risks must a

pension scheme understand before

considering an insurance-linked

securities (ILS) allocation?

Adam Beatty: Understanding volatility is vital. For an asset class such as this, pension schemes must be aware of the complete risk/return distribution; especially in relation to the downside risk. In catastrophe risk, the return distribution is not normally distributed around a peak mean but instead has a left tail bias. This essentially means that there will be some downside years in the tail of the distribution. However, for a large proportion of the time, not much happens with regards to losses with returns being above the long-term mean expected rates.

On the performance risk side, the key is to understand the market dynamics of capital supply, the demand for reinsurance risk and the pricing levels generated. Investors must ask managers whether that level of pricing, supply and demand is sufficient to generate the type of targeted return required but within the downside risk constraints of a particular ILS mandate.

There is some liquidity in catastrophe (CAT) bonds but generally speaking reinsurance risk is a fairly illiquid

strategy. A portfolio that’s invested more broadly across different ILS instrument is going to be relatively illiquid; think 90 day redemption terms typically.

Elizabeth Garner: From a defined benefit (DB) pension scheme viewpoint liquidity is not so much of an issue, providing we can of course extract our money at some point. The volatility and how that transcribes onto performance risk, is more of an issue because you could potentially lose all of your money. It’s not so much about the way in which the bond’s liquidity might actually change but rather that your capital could be at risk whilst you are seeking a higher return.

Jens Hagendorff: I’ve spent quite a lot of time looking at whether a risk transfer is occurring and find, that investors who invest in CAT bonds actually assume catastrophe risk. I would also add model risk to the list; how reliable are the models used to determine the expectant losses as a result of a natural catastrophe?

ILS investors assume some catastrophe risk and whilst there are very established models out there for determining the amount of risk assumed, it is possible that these models could still underestimate the

risk. This is most prominently seen in areas such as flooding and the like where the models are having to be revised again to reflect the reality that such catastrophes are occurring more frequently. As these models are revised there will be an awful lot of investors that have assumed more risk than they presently realise. So whilst currently a theoretical risk, going forwards, it could have a huge impact on the market.

Steve: As ILS instruments have

evolved have you felt threatened by

the emergence of any new risks?

Elizabeth: I don’t feel that the instruments have led to an emergence of new risks but rather that the issue remains to be around old risks. We have to consider the Lloyd’s Register type of risks that are now coming into the mainstream with plenty of pension funds taking on this risk. Then there are other risks such as global warming which of course will probably increase the catastrophe risk for all parties invested. I don’t feel threatened by it though but rather feel it’s a case of trying to understand what that risk is in the first place.

Adam: The evolution of the asset class and the instruments traded is not something that we feel threatened by;

55



on the contrary we see it as an exciting part of the market. New capital that has come in from institutional investors has spurred innovation in the ILS marketplace. On the subject of new risks, we are increasingly seeing other managers diversifying their insurance exposures to incorporate more than just natural catastrophe risks. Some are getting involved in the marine, aviation and terrorism markets; although at Nephila we haven’t been pursuing such areas. Generally there is less need for incremental capital in those markets and arguably a lower expected return. This means that diversifying into those areas may not necessarily be in investors’ best interests.

Jens: It’s great that there have been a take-off of investments in this market. Though I do wonder whether the nature of the securitised risks are the same, or whether they are becoming riskier. There is presently a lot of indemnity based triggers in the CAT bond market whereas previously very few insurers actually issued CAT bonds with indemnity based triggers because institutional investors were wary of such arrangements. The slight worry I do have though is around increasingly risky events being securitised because it might lead to investors taking on more risk than they realise.

Steve: Do you feel that the

introduction of broader terms and

conditions as transactions made to

resemble traditional reinsurance and

the addition of modelled risk will

increase this asset class’ volatility?

Jens: It’s pretty transparent as it is but there are certain types of indemnities and risks that previously few investors would have selected whereas now, there’s so much demand for CAT bonds that investors are less cautious. One of the really odd things about the CAT bond market was that until very recently the returns were very good, largely because insurance companies were very cautious in the types of risk that they securitised, and investors were getting a very good deal, but now

this seems to have ceased.

Steve: Within

catastrophe risk

why should pension

funds look to

diversify the ILS

instruments they

use?

Adam: This is a very interesting question and can be approached in two ways.

If you asked a computer allocation model to analyse this sector it would say that since this asset class is very diversifying with very low correlation to other strategies and normally a small allocation for the pension scheme, then it actually makes sense to focus on the best paying risk in the asset class and accept a lot of volatility. The computer is likely to say, do not diversify much and stay concentrated on the best paying risk.

However, it’s fair to say that a number of investment committees and trustee boards won’t be entirely comfortable with that type of risk/return profile because ILS is still viewed as a relatively esoteric, alternative asset class. A number of investors want to instead take the uncorrelated return stream and seek to reduce the volatility. Perhaps by replicating some kind of fixed income type return but without too much downside risk. We see both approaches and have investors on our platform that are seeking to follow both of those different philosophies.

Elizabeth: Adam is absolutely right. As an investor you may want it to give you a higher return in the short-term but are concerned about a total loss for that bit of capital. Consequently it’s important to spread your risk and look for many small little investments within the bond that you’re holding in order to ensure that there is less risk of losing that capital. To assess this, particularly if we’re talking about lay trustees on a

pension trustee board, you need the experts.

Jens: Both Elizabeth and Adam pointed out quite rightly that the key issue here is the risk of a total loss which we have with very few other types of investment. Therefore, diversification within the ILS asset class is pretty important. The trouble though with diversification in ILS securities is that a lot of the instruments have fairly similar risks: U.S. based risks and wind based risks. Within that asset class, certainly for CAT bonds, it’s not very easy to diversify. Some of my industry contacts tell me that there are some German primary insurers keen to issue CAT bond risk to flooding for instance, but it still seems to be very much in the pipeline.

Adam: As Jens correctly points out, the CAT bond market is very concentrated around U.S. hurricane risk and so any element of possible diversification has some inherent limitations. It is valuable to diversify across instrument types and to be able to transact across the broader reinsurance market. By doing this a manager is able to help create a much larger investable universe. The more positions you have to choose from the easier it becomes to control downside tail risk for a given level of return.

Steve: I come across a lot of

investors now actively seeking non

diversification, in that they are

investing a small amount of their

portfolios in, most predominately,

U.S. wind risk. What do you think of

“take the uncorrelated return

stream and seek to reduce the

volatility. . .”

56


that as a strategy and will it always be

a small part of the market?

Adam: It’s a very valid strategy and mathematically is what portfolio theory tells you to do when investing a small allocation in an asset class inherently uncorrelated to the rest of the portfolio. Certainly many investors have that mindset but it’s not for all. There’s presently a battle with human nature whereby people prefer to spread their risks a little in order to control their downside tail risk; even though as a strategy the former is perfectly valid.

Jens: As a strategy I understand its validity. We have to bear in mind though that we’re looking for low levels of volatility linked to CAT bonds; this is why a lot of these mean variance portfolio optimisation approaches say it’s a good strategy. That said, what a lot of investors have to bear in mind though is that even with a low average volatility there are incidences, because of peak risk, where losses can be very large indeed.

Steve: Is there currently enough

supply in the marketplace to account

for different risk appetites, tactical

and strategic investment objectives?

Elizabeth: It’s really an observation but a lot of people I talk to are now either in ILS or considering ILS. Going back 5 years ago this wasn’t the case. I don’t quite know what’s caused this change and if you are a sceptic then you might say it’s because the insurance market is trying to spread risk away from themselves. Whether that makes it a

good product or not, I put the question out there as to what’s actually driving this change. Overall though I haven’t heard people report that they’ve been unable to buy bonds or that they consider the price to be too expensive.

Adam: The reason we’re seeing institutional investors becoming increasingly interested in this asset class is because of the fundamental attraction of an uncorrelated, investable asset class. In addition to the diversification there is also a positive expected return over time. These investors are bringing efficient capital to the market with a lower cost of capital than some of the incumbent reinsurance capital. This in itself is attracting reinsurance risk supply to managers like ourselves who are allocating this efficient capital on behalf of investors.

Coming back to the question, is there sufficient supply for different risk appetites? The answer is yes; products in the market range from mid-single digit target returns up to 25% or 30% target returns. This means there is a pretty broad risk and return framework available to investors and that the market is able to accommodate all of sorts of risk/return profiles. It’s probably fair to say, most of the institutional money that has come into the sector over the last 2 or 3 years is looking for 5% to 15% returns maximum which the market has been able to accommodate reasonably well to date.

Steve: In 2014, so far, the CAT bond

market has seen transactions with

on average premiums of between

2% and 4%, obviously a lot lower

than recent years. Do you feel that

investors will increasingly look to

private transactions and traditional

reinsurance contracts to boost their

returns if the CAT bonds can’t provide

the return?

Adam: It makes sense to look beyond the CAT bond market when constructing a portfolio in this sector anyway. A larger investible universe should mean a given return target can be reached with less downside tail risk. Investors will possibly start to look further at the market’s lower returning sectors and come to the conclusion that they will need to be invested in more than just CAT bonds to create an attractive portfolio with the more remote risk instruments included.

Steve: Pension schemes are not

involved in the high-level risk

modelling behind ILS. Is this a reason

to hold back from allocating or is it

unrealistic to expect asset owners

to have the detailed knowledge of a

funds complex make-up?

Elizabeth: In my previous role at the Atkins Pension Plan, we were more concerned about being satisfied that there was sufficient diversification to make it an acceptable asset class for us to invest in. At Save the Children, there’s much more emphasis on being able to see what’s happening and with CAT bonds it is felt that there could be a conflict between people dealing with the different areas of catastrophe.

Jens: It’s important to bear in mind that the risk modelling for ILS products is done by external bodies and therefore, pension schemes don’t need to understand the detailed complexity behind it. On top of that I would argue that because of funds invested in ILS there is now an intermediary solution out there with an expert who understands a great deal more about the risk modelling and individual risks linked to those securities. I understand that the fees for those funds are pretty high, somewhat in the region of hedge funds. However, as a number of pension funds already invest in hedge funds, the fees shouldn’t be too much of a deterrent.


“how reliable are the models

used to determine the expectant

losses as a result of a natural

catastrophe?”

57



Adam: It hasn’t held investors back from allocating to this sector and one of the issues with the asset class is that there isn’t really an investable beta for investors to access. Pension schemes may decide it makes sense to use a manager for multiple reasons including for their expertise in risk evaluation and market access. In addition, they get value from the managers’ relationship with brokers, counterparties and broker dealers in order to access the risk.

We make a large amount of portfolio detail available to our investors to allow them to drill down and ask specific questions about portfolio strategy. It’s also worth mentioning that some institutional investors do actually licence the models, or parts of them, so that they can compare certain CAT bonds or look at a CAT bond portfolio or to compare the risk/return curves being shown to them by multiple managers. There is certainly some sophistication and familiarity with the models amongst the investor base.

Steve: As the ILS market expands

and broadens out to include more

traditional reinsurance in private

transactions, it seems to me that

the skillset of the manager in

selecting risk will become even

more important. Do you feel we’ll

see a move as people explore who

the best managers are and will this

exploration result in capital flow from

one to another as investors choose

their preferred managers? Secondly

do you think managers are going to

have to increase their skillsets and the

size of their teams?

Elizabeth: They will have to prove to investors that there is skill and science behind what they’re doing. I’m sure that those running the asset classes will be nudged to do so as demand increases.

Adam: It’s absolutely necessary for managers to demonstrate that they are adequately resourced with the right skillset to execute the portfolios proposed to investors. Investors are

interested in the depth of staffing and resources that managers have at their disposal and I would expect this to become more important as the asset class grows. There’s already fairly robust competition between managers but in terms of capital moving from one to another I’m not sure about that. Investors have a reasonably broad choice of managers in the sector and already ask the right sort of questions of those managers before they commit their capital.

Jens: ILS is just one of a number of new securities that a lot of asset managers are looking at. This increased interest is as a result of the current, relatively low equity returns and other fixed income securities. Generally skillsets are widening in the industry. I’m working with a few Edinburgh fund managers who are looking closely at areas such as infrastructure projects, but remain very aware that it’s not area where their primary expertise is. That said, it’s an area where they are willing to invest in those skillsets in order to keep up with the times. To conclude ILS is just one of a number of possibilities where investor skillsets will have to widen.

Steve: Thank you all.

“pension schemes don’t need

to understand the detailed

complexity. . . ”

Contact us at [email protected] or Visit us at www.nephila.com

San Francisco, CA

2257 Larkspur Landing CircleSuite FLarkspur, CA 94939 USAT: 1 (415) 799 4099

Nashville, TN

3811 Bedford AvenueSuite 101 Nashville, TN 37215 USAT: 1 (615) 823 8488

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Victoria Place, 3rd Floor West, 31 Victoria Street Hamilton, HM10 BermudaT: 1 (441) 296 3626

Markets Change.Weather Changes.Nephila’s focus remains the same.

Nrange of investment products focusing on instruments such as insurance-linked securities, catastrophe bonds, insurance swaps, and weather derivatives. Nephila has assets under management of approximately $10 billion as of April 1 2014 and has been

based in their Bermuda headquarters, San Francisco, CA, Nashville, TN and London.

59



Steve Evans


Dr. Erwann O. Michel-Kerjan

Managing Director, Risk Management and Decision Processes Center, The Wharton School, University of Pennslyvania


6.3 INTERVIEW

Steve Evans: What key changes have

there been to ILS risk spreads over the

last year?

Dr. Erwann O. Michel-Kerjan: Over the last 18 months there has been a gradual slide in rates which has helped make these products more affordable for those who are issuing the bonds. However, on the demand side this has resulted in lower returns, of course.

There are three drivers that explain this recent trend, with the first being the overall current capital market conditions. 2013 was free from any significant catastrophes which subsequently resulted in a large amount of available capital in the reinsurance market. Typically, if the rate-on-line of a reinsurance product drops, so does the rate of the catastrophe (CAT) bonds (reflecting cheaper capital available). We’re now seeing ILS premiums below 500 points above the collateral threshold. Although this is much lower than the 8% or 9% seen a few years back, I would argue it is a natural variability of the market.

The second driver is around the subtleties between different types of CAT bonds and the types of products actually being sold. One often hears about the ILS market as if it were homogeneous; it’s not. The price of two different cat bonds, for instance, will be higher or lower depending on what the expected loss is for these two products. Many of the new issuances we have seen trigger with a higher return period (i.e., lower likelihood and lower expected loss); in effect, that

means investors are actually being compensated for taking on less risk.

All of that can quickly change, though. If a big disaster occurs in 2014, spreads are likely to start increasing again.

This leads me to the third driver: how the financial markets are doing. 2013 was a remarkable year in the U.S. with the S&P 500 gaining 20%. That said, now all eyes are on the market with some anticipating that we could be on the verge of another financial crisis, or at least a severe correction. Add to that Europe’s rocky situation and the lower than expected growth in several emerging markets, and the picture is a little bit more scary. All of these factors have the potential to impact the cost of capital in the short and long-term.

Steve: There is momentum behind

market growth but how can this be

ramped up further over the next 5

years?

Erwann: This can be approached from two ways: knowledge and simplicity, both of which will lead to a larger and more liquid market.

Firstly, we should celebrate that the CAT bond market is currently above $20 billion of outstanding capital, far more than in the past, and so clearly the ILS market is moving in the right direction. Can we double it in the next 5 years? The answer is certainly yes.

Experience shows that we need to provide greater education around the specific products targeted to a large spectrum of investors who, in

the main, are not used to dealing with probabilistic risk assessment on natural disasters, terrorism or pandemics. In order to convince pension funds that ILS is a good addition for a small part of their portfolio, they need to understand what they’re buying as it’s not just finance but science, climatology, engineering and medicine. These are two different worlds whereby engineers and pension fund managers won’t be talking to each other, but it is imperative that they do and start to understand the catastrophe risk modelling behind the pricing of these bonds. This has already started to happen.

Education is a big part of the equation, particularly if you consider that the return of these bonds must fit into a pension fund’s long-term time horizon. An interesting parallel is the recent issuance of green bonds for instance (by Zurich Insurance Group). Several very large asset managers are also looking at this market. The more alternative bonds that we see added to municipality bonds, the more mainstream these CAT bonds will become.

Second - simplicity. We have to make these instruments simpler; almost by definition this is how you will make both investors and issuers cross the decision line.

Also, only a few of the 250+ CAT bonds issued have triggered. I’m not saying more need to be triggered, but because only a handful of them have, some people question whether they might be paying the premium

60



for nothing, because the attachment point is too high. You can imagine many more bonds being issued with tranches that would trigger at a lower level. Parametric bonds of that nature should appeal to a large number of issuers which one could pool together, rather than having only one issuer at a time, which results in high administrative costs and fees. By pooling issuers you reach economies of scale. Think of a Category 3 hurricane hitting Miami-Dade next year. I could think of a number of public and private organisations that would benefit from post-disaster funding. If you pool issuances and pool buy-ins (through a CAT bond index), we would certainly make a significant progress is making this market more liquid.

Steve: What do you think we need

to do to get these products into

emerging economies?

Erwann: It goes back to education. Many of these discussions on the disaster management side are typically handled by the Ministry of the Environment (natural disasters) or the Ministry of Health (pandemics). In most countries neither has the financial expertise to understand ILS. On the other hand, whilst the Ministry of Finance does, they are too removed from the handling of catastrophes, until after a disaster when relief is needed. Experience shows that when you bring those decision makers together, then actions can be taken.

Steve: What new measures are

governments, rating agencies and

other key market players considering?

Erwann: Historically, ILS has been regarded as a private sector product. That said, over the past few years there has been bond issuance by state insurance programmes such as the California Earthquake Authority and the Florida Hurricane Catastrophe Fund.

Governments around the world have now started to put the question of

disaster risk financing on their agenda at a more strategic level. For instance, I participated in the 2012 G20 Summit in Mexico where the Mexican Presidency assembled a dedicated group to help finance ministers and senior policy makers think more strategically about disaster financing. This was the first time that G20 members considered that topic to be a priority.

I’ve been privileged to have spoken several times at the World Economic Forum in Davos and can equally say the topic is becoming increasingly important on their agenda.

Certainly insurance (and ILS) is not the only solution but it should definitely be part of the solution. Another interesting trend I’m observing comes from the rating agencies, which are obviously a key player. They are now increasingly including a corporation’s risk management plan into their assessment - and not just financial risk management, but operational, too. Although they aren’t downgrading a corporation for not doing X, Y and Z, they are emphasising the importance of proper risk management.

If this rating trend observed in the business community moves to the public sector, that will be a key change. One could easily think of the necessity to rate a sovereign bond or a municipality bond with some consideration being given to how exposed this country or city is to disasters. After all, disasters have proved to be a key driver of loan default for small businesses around the world. If central governments are faced with increasing demand for providing free relief disaster after a disaster, pressure will increase for finding alternative risk financing solutions to be put in place before a catastrophe,

rather than relying on taxpayers’ money. This is happening here in the United States and in the UK too as we speak.

Steve: Catastrophic risks have

enormous financial impact for

businesses and countries. What is

happening?

Erwann: That’s a big question. Over the past decade there has been increased occurrence of more devastating catastrophes. When one looks objectively at the important metrics, all of them are in the red; more devastation is to come, much more.

Metric 1: population. We added 2 billion people on planet Earth in the past 20 years alone; 2 billion! Many of these individuals live in hazard prone areas, so we mathematically increase the overall exposure.

Metric 2: assets at risk. As people move out of poverty (a lot remains to be done here) and many more people enter the middle class, they purchase more, then more assets are in harms’ way.

Metric 3: aging infrastructure. This is certainly the case in the US where trillion of dollars of investment are needed just to modernise our fairly old infrastructure.

Metric 4: interdependency. Moreover, our world is more globalised and interdependent than ever before. Something happening 5,000 time away from where we are can have a ripple effect onto us fairly quickly. A massive

“it’s not just finance but science,

climatology, engineering and

medicine. . . .”

61



flood in Thailand, for example, affects the world global supply chain. In other words, we are exposed, directly or indirectly, to more sources of destabilisation.

Steve: Given that risk spreads

have declined do you think it

could encourage more country- or

municipality-level risk transfer?

Erwann: Of course. Moving down from 8% to 5% premium is a big difference. ILS also typically provides premium stability over several years, a critical advantage that has been totally underappreciated in today’s highly volatile world. There has been much discussion with insurance companies about whether they would be ready to issue fixed rate insurance contracts for 3 or 4 years and whilst the answer has been ‘no’ as of yet, CAT bonds have provided stability, reassuring to the treasurer of any corporation or city.

Steve: What direction will risk spreads

head in in both the short- and long-

term?

Erwann: It could go down or up. Down if we are lucky again, if there are no big disasters in 2014 and the financial markets keep moving up. Maybe 50 points or even 100 points. But they could go up again if there is a series of large catastrophes and/or a severe correction of the financial markets affecting the availability and cost of capital.

That said, one also need to be careful not to compare apples to oranges. There are many different ILS products, so spread will of course depend on the nature of the transaction and risk involved.

Steve: What do you see as the

challenges of expanding the remit

of ILS and CAT bonds to better assist

with narrowing the disaster gap

globally?

Erwann: Globally the larger question is who should pay for catastrophes.

The public or private sectors? And when? Before (insurance) or after (ex post compensation)? How countries and markets respond to these two questions will largely determine the future of the ILS market.

Historically we looked to governments as the ultimate risk managers; that is true even in the U.S, often depicted as the most market-based economy. But if we take the U.S. catastrophes over the last 50 years we see the cost of these disasters increasingly borne by the taxpayers. Consider the following: when Hurricane Diane hit in 1955 only 6% of the aftermath costs were paid by the American taxpayers but by Hurricane Katrina in 2005, this number had risen to 50% and then 80% for Hurricane Sandy in 2012, that’s 80%! Some would say this is hardly a market economy.

Whether this will be the new norm for America, because it would be hard for any future Congress not to follow precedent, is unclear. This could also be a tipping point. This has indeed resulted in elected officials debating as to who should shoulder the responsibility of relief. It took U.S. Congress 3 days to vote $50 billion of relief after Hurricane Katrina in 2005 but for Hurricane Sandy it took Congress 3 months of intense debate to vote for the same $50 billion of relief. What happened in between? A world financial crisis that had severe impact on national debt. Subsequently, if we don’t want taxpayers to carry the cost of future extreme events, we will have to hedge some of these financial liabilities. Players in the supply and demand sides of the ILS market should be at the discussion table.

This reminds me of earlier discussions at Wharton in the early 1990s where the concept of cat bonds was first introduced. Twenty-five years

have passed and the market is growing but could be potentially immensely larger. One just needs to be innovative to create value, and a decent return.

Steve: Thank you Erwann for that

alternative perspective.

Erwann: It has been my pleasure talking to you.

“It took U.S. Congress 3 days to

vote $50 billion of relief after

Hurricane Katrina in 2005. . .”

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