INSURANCE LINKED SECURITIES FOR INSTITUTIONAL …€¦ · Tangency Capital is an employee-owned...

INSURANCE LINKED SECURITIES FOR INSTITUTIONAL INVESTORS 2020

A burgeoning asset class in a challenging market

JUNE 2020

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CONTENTS

SECTION 1 INVESTMENT STRATEGIES 7 1.1 INTERVIEW Diversifying sources of risk in a maturing ILS portfolio – where are

portfolio managers setting their sights? Interviewer:

• David Grana, Head of Production, Clear Path Analysis Interviewee: • Bernard Van der Stichele, Portfolio Manager, Healthcare of Ontario Pension (HOOP) Plan

9 1.2 WHITEPAPER Driving capital efficiency in ILS investments • Dominik Hagedorn, Partner, Tangency Capital

12 1.3 INTERVIEW Has a large scale and long-term approach been successful in delivering

a positive net-return? Interviewer:

• David Grana, Head of Production, Clear Path Analysis Interviewee: • Dan Bergman, Head of ILS & Timberland Investments, AP3

14 1.4 INTERVIEW Low correlation has become the key driver to ILS appetite Interviewer:

• David Grana, Head of Production, Clear Path Analysis Interviewee: • Nikki Hall-Jones, Director of Investments, Willis Towers Watson

SECTION 2 A VIABLE ASSET CLASS18 2.1 INTERVIEW The resilient ILS market is showing clear signs of growth Interviewer:

• David Grana, Head of Production, Clear Path Analysis Interviewee: • Jeff Mohrenweiser, Senior Director, Insurance, Fitch Ratings

21 2.2 INTERVIEW Investors are facing learning curve when it comes to ILS Interviewer:

• David Grana, Head of Production, Clear Path Analysis Interviewee: • Courtney Wilder, Senior Consultant, JANA

Bernard Van der Stichele, Portfolio Manager, Healthcare of Ontario Pension (HOOP) Plan

Dominik Hagedorn, Partner, Tangency Capital

Dan Bergman, Head of ILS & Timberland Investments, AP3

Nikki Hall-Jones, Director of Investments, Willis Towers Watson

Jeff Mohrenweiser, Senior Director, Insurance, Fitch Ratings

Courtney Wilder, Senior Consultant, JANA


CONTENTS

SECTION 3 NEW DEVELOPMENTS 25 3.1 INTERVIEW ILS and cat bonds can help investors in achieving their

ESG objectives Interviewer:

• David Grana, Head of Production, Clear Path Analysis Interviewee: • Greg Wojciechowski, Chief Executive Officer, Bermuda Stock Exchange

27 3.2 INTERVIEW Will COVID-19 open up the pandemic bond market and will investors be

willing to participate? Interviewer:

• David Grana, Head of Production, Clear Path Analysis Interviewee: • Marcos Alvarez, Senior Vice President, Head of Insurance, DBRS Morningstar

29 3.3 INTERVIEW Hong Kong aims to become hub for ILS issuance Interviewer:

• David Grana, Head of Production, Clear Path Analysis Interviewee: • Mr. Simon Lam, Executive Director, Insurance Authority of Hong Kong

Greg Wojciechowski, Chief Executive Officer, Bermuda Stock Exchange

Mr. Simon Lam, Executive Director, Insurance Authority of Hong Kong

Marcos Alvarez, Senior Vice President, Head of Insurance, DBRS Morningstar

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Nephila is a pioneer and leading investment manager specializing in (re)insurance, climate and weather risk. The firm has been active in the ILS markets since launching its first fund in 1998 and offers a broad range of investment products focusing on instruments such as insurance-linked securities, catastrophe bonds, insurance swaps, and private transactions across its robust platform. Nephila has approximately $10.2 billion in assets under management as of May 1, 2020 and is headquartered in Bermuda, with offices in San Francisco, CA, Nashville, TN and London. There are currently over 250 employees with expertise in finance, seismic engineering, catastrophe modeling, risk management and traditional underwriting.

Tangency Capital is an employee-owned alternative investment manager focused on the insurance sector. We aim to create value for our shareholders by co-investing in portfolios of re/insurance companies to generate uncorrelated investment returns.

From our perspective, the key benefits of our investment approach are proportional alignment with best-in-class portfolio companies, which provide non-recourse leverage, global diversification and capital efficiency.

Founded in 2017, the company has since grown to more than $400mm under management. Our team consists of 6 seasoned professionals with combined 90+ years of industry experience and diversified skill sets, including underwriting, actuarial, geoscientific research, investment banking and accounting.

SECTION 1INVESTMENT STRATEGIES

1.1 INTERVIEW

Diversifying sources of risk in a maturing ILS portfolio – where are portfolio managers setting their sights?

1.2 WHITEPAPER

Driving capital efficiency in ILS investments

1.3 INTERVIEW

Has a large scale and long-term approach been successful in delivering a positive net-return?

1.4 INTERVIEW

Low correlation has become the key driver to ILS appetite

Insurance Linked Securities for Institutional Investors 2020 7

Section 1 - Interview

Diversifying sources of risk in a maturing ILS portfolio – where are portfolio managers setting their sights?

1.1 INTERVIEW

David Grana: For how long has HOOPP invested in ILS and how has the asset class performed?

Bernard Van der Stichele: ILS is a new investment strategy at HOOPP and it is therefore too early to comment on performance.

David: What was the appeal for HOOPP’s decision to allocate to ILS?

Bernard: The primary characteristic of ILS which makes it attractive to investors is the low correlation of the ILS market’s performance relative to that of other asset classes and investment strategies. As long as this lack of correlation persists and as long as investors are appropriately rewarded for the risks they take, it makes sense for long-term investors to consider some level of exposure to the asset class.

David: Does the change in the markets and economy since the beginning of the year change your view of ILS and the level of allocation?

Bernard: No. While the ultimate impact of COVID-19 on property catastrophe reinsurance remains uncertain, the ILS market’s response to the economic downturn is, so far, within expectations. It is in times like these that the diversification value of ILS manifests itself. That being said, the COVID-19 uncertainties do bring to light aspect of

property insurance underwriting practices which may concern some investors and raise questions.

David: What precautions or changes in strategy do you see ILS investors making with the increased threat of climate change, and more recently, of pandemics?

Bernard: Having been involved in the ILS market, and therefore the business of evaluating natural catastrophe risk for many years I have always considered climate change as a risk factor and my own perception of it hasn’t changed. As with any risk factor, there are two aspects to consider: Firstly, its contribution to overall risk in absolute terms. This means evaluating whether the models and data at our disposal account for climate change risk, directly or indirectly, on an appropriate time scale. Secondly, an investor must consider if and how this risk factor is being priced by the market, just as any other risk factor. Pricing risk always entails a balance between competitiveness, return requirements and risk minimization. It is no different for climate change risk.

David: Do you see the asset class evolving, such as in shifting its focus towards different risks?

Bernard: I hope the asset class will continue to evolve as it has since its early days, however, I expect the focus will remain mostly on

Interviewer Interviewee

• Low correlation to overall market performance is the primary characteristic that makes ILS attractive to investors

• While the ultimate impact of COVID-19 on property catastrophe reinsurance remains uncertain, the ILS market’s response to the economic downturn is within expectations thus far

• The size of the ILS market must be a function of the demand for alternative risk capital, creating a natural limit to the size of the asset class

• The ILS investor base has grown significantly since the early days of the market and investors will continue to enter/leave the market in response to the relative value of ILS versus other assets

Bernard Van der Stichele, Portfolio Manager, Healthcare of Ontario Pension (HOOP) Plan

SUMMARY

David Grana, Head of Production, Clear Path Analysis



natural catastrophe risk (both non-life and life). I believe any ‘new’ risk presented to ILS investors should meet four fundamental criteria:

1. The risk-transfer to the ILS market must be motivated by a clear need for alternative risk capacity

2. There needs to be some track-record demonstrating the traditional reinsurance market’s ability to evaluate and manage this risk exposure over time

3. The risk can be quantified and adequately priced

4. The new risk has low correlation relative to other asset classes

David: What needs to happen for investors to embrace ILS as a mainstream asset class?

Bernard: As alluded to earlier, I believe the size of the ILS market must be a function of the demand for alternative risk capital and thus there is a natural limit to the size of the asset class. The investor base has grown significantly since the early days of the market, and investors will continue to enter/leave the market or scale their participation in response to the relative value of ILS versus that of other investment opportunities. The fact remains that ILS is a specialist market and, on the whole, investors remain exposed to a significant level of information asymmetry. All these factors tend to limit the extent the level to which the ILS market can grow, either in terms of risk capital or investor base.

David: Is it important to have in-house expertise of the asset class?

Bernard: I think it is. Being involved in the ILS market directly, whether via cat bond trading or direct participation in other transactions leads to a better appreciation of market dynamics, underwriting practices and risk exposure. Furthermore, the experience allows an investor to benefit from more nuanced conversations with other market participants (e.g. brokers, fund managers, cedants) which, over time, lead to better investment decisions.

David: Thank you for sharing your thoughts on this topic.

THE INVESTOR BASE HAS GROWN SIGNIFICANTLY SINCE THE EARLY DAYS OF THE MARKET, AND INVESTORS WILL CONTINUE TO ENTER/LEAVE

THE MARKET OR SCALE THEIR PARTICIPATION IN RESPONSE TO THE RELATIVE VALUE OF ILS VERSUS

THAT OF OTHER INVESTMENT OPPORTUNITIES


Section 1 - Whitepaper

Driving capital efficiencyCapital efficiency has become an increasingly important part of investment decisions in the ILS sector, as losses in recent years have shown that conventional fully collateralized reinsurance structures reduce capital at risk when needed the most – after catastrophe events have occurred and rates rise.

The value of diversification The insurance model was built on the principle that through risk sharing, diversification and the law of large numbers, balance sheets operate more efficiently. Insurers often need proximity to policyholders and therefore run their business locally, while virtually all reinsurance companies manage globally diversified books. Why? Because if a reinsurer provides protection for U.S. hurricanes, the incremental capital charged for covering Japanese earthquake is much lower. The two perils are uncorrelated and the likelihood of both occurring in a severe fashion at the same time is very low. This capital efficiency is generated in economic capital as calculated by rating agencies as well as in regulatory capital calculations. Consequently, the more diversifying perils are covered on the same balance sheet - and the more risk-adjusted margin is earned - the more a reinsurance portfolio benefits from the economic leverage and expected returns improve. Within the property treaty excess of loss reinsurance segment alone, this risk to capital leverage is often 4-6 times.

Why should end investors collateralize tail scenarios beyond what rating agencies care for? But that kind of capital leverage is far from being standard in the ILS sector. When investing in conventional collateralized reinsurance structures, ILS funds typically are asked to provide dollar for dollar on the liabilities assumed, unless fronting or in-house leverage facilities are employed – both of which are fairly expensive options. By investing in a portfolio of such fully collateralized deals, investors put up much more capital than would be required economically when combining those transactions. As a result of the investment structure, end investors collateralize portfolio tail scenarios beyond what would be required by regulators and rating agencies from rated entities.

Driving capital efficiency in ILS investments

1.2 WHITEPAPER

Dominik Hagedorn, Partner, Tangency Capital

• After the recent years of elevated loss activity, we expect investors to increasingly focus on capital efficiency

• Traditional ILS investments often fully collateralize all of their obligations beyond what would be required economically in a portfolio

• Quota shares offer a way to access portfolios of reinsurance risk with partial collateralization, generating non-recourse leverage

• Those investment arrangements also often employ rolling capital structures, which eliminate capital buffers at renewal

SUMMARY



Quota shares reduce that inefficiencyBut it doesn’t have to be that way: By co-investing with reinsurers through quota shares, end investors have the opportunity to benefit from the economic capital leverage that the reinsurance business is built on, without any recourse beyond the invested amount. What’s more, diversified portfolios are also better suited to withstand large natural disasters due to lower concentrations of individual perils. And when disasters occur, investors will want to be particularly mindful about capital efficiency.

Capital buffering may cause a significant drag on investor performanceAfter several years of elevated insured loss activity, ILS investors have become all too familiar with the notion of “buffer capital” – the invested capital that is held back at the end of a risk period to allow for adverse development of expected claims. Timing delays can come from a variety of factors, including late claim filing, prolonged claims review, litigation, and others. As buffer capital serves the specific purpose of covering potential adverse development, it is put in collateral trusts earning money market fund returns, thereby creating a significant drag on the investment performance. And such capital buffers may be non-trivial amounts: we are seeing many cases across the ILS space in which 200% of the reserved loss amount is retained at the end of the risk period to cover losses and potential adverse development. Put in perspective, Aon Securities estimated that by Q3 2019, more than 15% of ILS capital had been trapped as a result of the 2017/2018 events, equaling about USD15bn, mostly due to capital buffering. While buffer capital schedules are contractually defined, and the multiplied percentage usually decreases every few months, end investors have very limited insight into claims development and uncertainty around expected timing of repayment makes it difficult to use such funds for capital planning.

Rolling capital structures remove bufferingAs a result of these concerns, Tangency Capital has broadly implemented a rolling capital structure in the quota share market, which does not employ any capital buffers for renewing transactions. At the end of the risk period, losses are valued based on the loss estimate of counterparties and that amount is set aside for loss payments. Any movement of reserves will affect the capital base of the subsequent year’s transaction.

If there is adverse reserve development, i.e., initial reserves were insufficient, the subsequent year’s cell is reducing its capital base to pay for the increase in prior year reserves with a lower capital base continuing to support the current exposure. If there are reserve releases, i.e., initial reserves were too high, capital is made available to be at risk in the subsequent year’s account. As a result, the invested capital sweats harder than being sidelined for potential eventualities.

In the graphs below, we show traditional loss buffering on the left and rolling capital structures on the right. Even in a year with positive returns, loss buffers may reduce the investable capital for subsequent years below the initial collateral since losses may develop adversely. In a rolling capital structure, which eliminate such buffers, capital is kept at risk in the second year, thereby earning more premium.

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A rolling capital structure eliminates buffers at renewal and makes invested capital sweat harder

Loss buffering has traditionally affected the earnings potential in subsequent years.



Fund technology in place to shield new investors from prior year developmentsOne key concern that investors may have with this approach is that as new investors enter the fund, they want to avoid being exposed to adverse developments from prior years’ losses. Vetted fund structures exist to ensure segregation of liabilities from prior year events, for example by awarding each investor its own share class and linked side-pockets.

Tangible performance benefitIn looking at a simulated portfolio of reinsurance quota shares for 2015-2019, which includes years with both high and low loss activity, we estimate that on average, this structure would have improved investor performance by about 80 bps, from 9.1% to 9.9% p.a. For an asset class in which the Eurekahedge ILS Advisers Insurance Linked Securities Fund Index shows an average performance of approximately 0.17% p.a. over the same time period, this underlines the importance and potential benefits that can be brought along through proper structuring of ILS investments.

More work to be doneInvestors often ask about lessons learned from the 2017/2018 events. In many cases, answers revolve around improved risk modeling. And sure, model improvements are key and are done continuously. But we believe it is more about capital efficiency and structure. What investment structure works best for end investors? Tangency Capital’s answer to that is diversification, leverage and rolling capital. With further losses expected across the insurance industry from Covid-19-related claims, the importance of capital efficiency will only increase.

Tangency Capital Ltd. is an alternative investment company focused on the insurance industry.

None of the information described in this article constitutes a recommendation, solicitation or offer by Tangency Capital Ltd. or its affiliates to buy or sell any financial instruments or provide any investment advice or service. The information contained in this article has been prepared based on Tangency Capital’s modeling, which includes subjective assumptions, and without reference to any particular user’s investment requirements or financial situation. Past performance does not guarantee future results and actual results may vary.

The information and services described in this article are not provided to and may not be used by any person or entity in any jurisdiction where the provision or use thereof would be contrary to applicable laws, rules or regulations of any governmental authority or regulatory or self-regulatory organization or clearing organization or where Tangency Capital Ltd. is not authorized to provide such information or services. Some products and services described in this article may not be available in all jurisdictions or to all clients.



Has a large scale and long-term approach been successful in delivering a positive net-return?

1.3 INTERVIEW

David Grana: Has AP3 experienced similar losses as the broader institutional market in ILS investments?

Dan Bergman: No. Unlike many other investors, AP3 has had positive returns every year since the inception of the ILS-program in 2008 through 2019. We will have to wait and see what 2020 brings. However, our strategy involves systematic risk-taking year after year with a heavy tail, and we have no illusion about not running into substantial losses at some point in the future. When that disaster happens, it is our obligation to pay for it. That is why we earn money all the other years. Our average return since inception is 7.6% per year (in USD), and during the loss heavy years, such as 2011, 2018 and 2019, the returns were plus 6.4%, 3.7%, and 4.4%. Although one should be humble about the element of chance, our 10+ year track record and post event-analysis has confirmed that our risk selection process is robust and has so far delivered above expectation.

David: Does AP3 plan on changing the way that it invests in ILS?

Dan: Again, no. We manage about $40 billion USD of assets on behalf of the Swedish people. We are a long-term investor and our main risk is equity risk. ILS has been and remains a strategic long-term diversification strategy for AP3. Our commitment to ILS is strategic and long term. This strategy looked promising on the drawing board about 10 years ago and has delivered above expectations. We see no reason to change this fundamental approach. That said, we continuously seek

to improve our market access and efficiency, in particular, to leverage our strong balance sheet and AAA-rating.

David: What precautions or changes in strategy do you see ILS investors making with the increased threat of climate change, and more recently, of pandemics?

Dan: Climate change is much bigger than ILS. It impacts all our investments ranging from listed equities, bonds, real estate, timberland investments and so on. The main reaction I see is fear - fear that ILS as an investment will perform poorly because of climate change. And there are two elements to this. One is a sound questioning of risk levels and models and whether they account for the changing climate correctly. The other is an irrational assumption that ILS as an investment is likely to perform worse in a changing climate when, in fact, the opposite is quite possible. The price of climate-linked risks can improve as these risks increase and the need for protection increases. Also, that same fear increases risk aversion which can translate into better pricing. The current corona outbreak is an interesting story and I expect it will trigger a reassessment of global pandemic risks. And, more broadly in the pricing of extreme mortality risks, on the balance sheets of the large reinsurance companies. This is a huge tail risk for the reinsurers and regulators may start to post tougher capital requirements on that tail risk, which may bring more of it to the ILS market, potentially attractively priced.


• AP3 has had positive returns every year since the inception of the ILS-program in 2008 through 2019

• ILS has been and remains a strategic long-term diversification strategy for the pension fund

• There exists an irrational assumption that ILS is likely to perform worse in a changing climate when, in fact, the opposite is quite possible

• The ILS market is too small and specific to ever become mainstream, more likely to be managed by hedge funds than directly by large pension funds

Dan Bergman, Head of ILS & Timberland Investments, AP3

SUMMARY




David: Do you see the asset class evolving, such as in shifting its focus towards different risks?

Dan: Yes, there are several interesting dynamics playing out. One is spearheaded by the World Bank and their effort to provide catastrophic insurance coverage to developing countries, for earthquakes, typhoons and pandemics. Another is the shrinking difference between the rate-on-line for peak zones as compared to other zones. Both of these developments broaden the number of risks available in the ILS space.

David: What needs to happen for investors to embrace ILS as a mainstream asset class?

Dan: I would be surprised if ILS would ever become a mainstream asset class: the market is too small and given the specific nature of each insurance company’s risk and the heavy tail, I would expect most pension funds to leave management of ILS to expert dedicated hedge funds. AP3 is an unusual exception to this as we manage these risks mainly in-house.


I WOULD EXPECT MOST PENSION FUNDS TO LEAVE MANAGEMENT OF ILS TO EXPERT DEDICATED HEDGE FUNDS



Low correlation has become the key driver to ILS appetite

1.4 INTERVIEW

David Grana: What has ILS activity been like since the COVID-19 pandemic hit global markets?

Nikki Hall-Jones: There has been a short-term pause on some new deals and new issuances, but that will mostly likely change once the market picks up. This is very similar to what happened during the 2008 Global Financial Crisis. Despite the recent volatility, you will continue to see a limited impact on ILS because of its low correlation to financial markets.

David: Do you feel that because it is an uncorrelated investment class that investors are starting to look to allocate more towards it?

Nikki: Right now, they are looking just to rebalance and reshuffle and to see how everything stabilizes out. Possibly in the next quarter or two they could potentially start to look at allocating more, but at the moment everything is really on hold. It has historically been a stable and attractive asset class that is poised to pick up again, especially given the lower for longer interest rate environment.

David: Has COVID-19 have any impact on ILS?

Nikki: The biggest part of the market for ILS is CAT bonds which are triggered from perils such as hurricanes, earthquakes and wildfires, which is not linked to COVID-19. On the whole, there may be some

impact on life/health-related risks and possibly business interruption losses, but that a very small portion of the market.

There was a pandemic bond issued by the World Bank in 2017, which was recently triggered due to COVID-19. This segment of the market had not gained a lot of traction prior to COVID. That may change given current events, but these bonds tend to be difficult to model and price. Traditional parts of the ILS market, such as CAT bonds, will continue to see growth.

David: What role does climate change in the ILS world?

Nikki: There have been discussions around ILS and climate change, however, climate change has a slow and long-term gradual effect on catastrophe risk. ILS, on the other hand, covers short-term risks, so I don’t see an impact at this moment.

David: Do you see any changes in the underwriting terms as the market changes?

Nikki: The market has always adapted over the years. Given the increased severity of natural disasters, continuous modelling has adapted to cover new types of risks and to change the language accordingly. That language will probably be tighter now for exclusions relating to the pandemic, and especially given what is happening now in the legal system with business interruption.


• There has been a short-term pause on some new ILS deals and issuances, which will mostly likely change once the market picks up

• Right now, investors are looking to rebalance and reshuffle their portfolios to see how everything stabilizes out

• Climate change does not appear to have an impact on ILS at the moment

• ILS weathered the Global Financial Crisis and will continue be an attractive asset class going forward

Nikki Hall-Jones, Director of Investments, Willis Towers Watson

SUMMARY




David: Are there other areas that insurers are looking to branch out into for ILS bonds issuance?

Nikki: The only area that I have heard talk around is cyber risk. However, there isn’t a lot of historical cyber data out there, making it hard to model and to price. With more employees now working from home, the threats of cyber-attacks are increasing. This may be an area that investors will begin to look more into as the industry gathers more data.

David: What are some of the concerns and general themes that you are hearing in your conversations with clients when it comes to their ILS segment of their portfolio?

Nikki: The ILS segment has not been a major concern so far, simply because it’s typically not correlated with financial markets.

During the heightened volatility period, there was some initial illiquidity in the secondary market. However, markets have since stabilized and ILS has been relatively immune to any market swings.

David: Was the Fed’s backstop of the bond market a benefit for ILS?

Nikki: It helped bring liquidity to the overall market, include ILS.

David: Is there any fear of future illiquidity in the market, specific to ILS?

Nikki: The Fed has been unprecedented in what they have been doing to stabilize the market. At the moment, I don’t see a major cause for concern within the ILS segment of the market. This has been a very solid asset class in the past and able to weather market volatility over the years. ILS weathered the last crisis and I honestly feel that it will continue be an attractive asset class going forward. I see an increased interest in ILS because of this lower for longer interest rate environment. As investors start to look for other areas to diversify with attractive returns, the attractiveness of this asset class will continue to grow.


THIS HAS BEEN A VERY SOLID ASSET CLASS IN THE PAST AND ABLE TO WEATHER MARKET VOLATILITY OVER THE YEARS

Independent

Aligned

Diversified

Levered

Capital-efficient

Tangency Capital

Tangency Capital is changing the way institutional investors access the

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SECTION 2A VIABLE ASSET CLASS

2.1 INTERVIEW

The resilient ILS market is showing clear signs of growth

2.2 INTERVIEW

Investors are facing learning curve when it comes to ILS



The resilient ILS market is showing clear signs of growth

2.1 INTERVIEW

David Grana: Looking at 2019, what are some of the challenges that insurance-linked securities have faced, and how has that affected their ratings?

Jeff Mohrenweiser: ILS which includes cat bonds, collateralized reinsurance, sidecars and ILW’s represented about 15% of global reinsurer capital in each of the prior 3 years. However, the great majority of ILS has been unrated over that same period. Consequently, there have been little to no rating impacts. This is in stark contrast to 15-20 years ago when multiple agencies were rating a single deal.

What I did see in 2019 was the ILS market trying to get back to solid footing following back-to-back elevated claim experience in 2017 and 2018 due to US hurricane activity (Harvey, Irma and Maria), California wildfires and Japanese typhoons. This caused many cat bonds failing to repay full principal or capital to become “trapped” waiting for final loss estimates or there was “loss creep” as claim estimates developed and rose over a 12-18 month period.

As a consequence, some investors were upset with how the ILS space had performed and there was a re-trenching. Possibly there were some naive investors who were chasing yield and did not believe there could be back-to-back sustained loss years and felt that was not what they had signed up for.

Another scenario is that there may have been contract features with details that were not fully understood by investors that caused trapped capital and maturity extensions. Although no one wants to lose money, it is equally upsetting not knowing when their money returned. Even if it’s 80 cents on the dollar, having their investment tied up beyond the expected period can be frustrating. Perhaps certain ILS managers did not do a good job of communicating the risks to their investors.

And manager performance varied greatly where a few were over-promising and under-delivering. Pricing these instruments can be difficult which can affect marks. There is also the challenge of operating a virtual company, whereby third-party claims adjusters, modellers, claim reviewers and such become scarce and delay their reporting. Thus, some ILS funds were acquired or dissolved.

With that being said, the market is very resilient and has come back strong. I think there has been a doubling-down on communication. Issuance during the first quarter of 2020 was nearly $5 billion, which is 80% greater than during the same quarter last year.

David: How have issuers gotten creative with their underwriting in order to attract capital?

Jeff: I think this is more of a supply issue from issuers than a demand issue from investors. We have seen a decline in risk spreads or over-


• ILS represented about 15% of global reinsurer capital in each of the prior 3 years

• There was an investor re-trenching possibly after some naïve yield-chasing investors sustained back-to-back loss years

• 2019 is the first time that reinsurers outpaced ILS

• There has been a decline in risk spreads or over-subscription in principal amounts, which indicates demand is higher than supply

• Financial market turmoil could have a knock-on or secondary effect on ILS

Jeff Mohrenweiser, Senior Director, Insurance, Fitch Ratings

SUMMARY




subscription in principal amounts which indicates demand is higher than supply. This has allowed issuers to push different risk perils into the ILS space, most notably, mortgage insurance. There was tremendous growth in 2019 and 2018 with issuance of $4.5 billion and $3.0 billion, respectively.

Earlier this year, Fitch rated a property cat bond, Stratosphere Re, in the investment grade category as the arranger / sponsor wanted to test investor appetite. This was the first investment grade rating in nearly 10 years.

In addition, there has been a push by some ILS managers to get closer to the underlying risk and become a direct underwriter, as opposed to being a receiver of risk. They believe if you go out and hunt for your risk, you have a better handle on your underwriting and align or match their capital. This has led to some unique alliances.

In reaction to loss creep and trapped capital, there has been a shift in recent cat bond transaction to use industry index or parametric triggers and per occurrence (or single) events. These are considered cleaner than indemnity trippers and annual aggregate (or multiple) events. Indemnity triggers carry extension risk because of the length of time is takes to settle claims that follow the fortunes of the sponsor. Parametric triggers, on the other hand, have very clear pay out parameters, thus eliminating the extension risk.

David: Are investors looking outside of cat-type ILS because of the length of time it takes to settle claims?

Jeff: I think investors were surprised how long it can take to settle a claim – it does not always happen overnight or a few weeks with a

picture from your cell phone; but rather months and over a year as roads are cleared and claim adjusters can review property damage.

Investors are interested in the insurance space, and as we mentioned, mortgage insurance related deals have become very popular over the last few years. There is a smattering of pandemic or mortality-related deals such as the World Bank IBRD CAR notes. Aetna, through their Vitality Re vehicle, has been a consistent issuer of bonds tied to medical loss ratios. The ILS space is dominated by US weather peril that anything you can do to dilute it such as other risk perils or regions is welcomed.

David: How might COVID-19 affect underwriting or ratings?

Jeff: On the whole, I don’t believe it will. Obviously, there will be pockets – most notably the World Bank pandemic bond has been triggered and will have a payout close to $200 million. Likewise, we previously mentioned Vitality Re – and although there may be costs associated with COVID-19 treatments, there is probably a larger savings due to people postponing elective surgeries.

A lingering question, not only for the ILS sector but for the P&C industry, will business interruption claims be covered under commercial property policies? Most policies have a pandemic exclusion clause and there must be physical damage but a number of lawsuits have been filed. If those lawsuits are successful, ILS may be hit if it is deemed they must follow the fortunes of the sponsor or if they do not have the same exclusions.

A LINGERING QUESTION, NOT ONLY FOR THE ILS SECTOR BUT FOR THE P&C INDUSTRY, WILL BUSINESS INTERRUPTION CLAIMS BE COVERED

UNDER COMMERCIAL PROPERTY POLICIES?



David: With what’s happening in the financial markets, does that have any bearing on the rating of ILS?

Jeff: It wouldn’t affect the rating on ILS, because property catastrophe events are independent of financial events, which is one of the selling points of a cat bond. Investors like the non-correlation element. However, those deals tied to mortgage insurance, which are much more correlated to the credit markets, could get tapped as one can expect an elevated level of mortgage defaults.

I see the current financial turmoil having knock-on or secondary effect on ILS. As the financial markets go, so goes the ILS segment. As mentioned, the first quarter 2020 had record issuance primarily in January and February. Since March though, both have been generally stagnant as investors want to keep their powder dry and wait for some market clarity.

There may be a slight exodus as short-term investors are looking for liquidity. We have heard they are selling their ILS holdings as those have held their value while other assets that are struggling right now. However, longer-term investors view ILS as a buying opportunity because now they can get into these cat bonds at attractive prices.

Today’s cat bond collateral is primarily invested in ‘AAA’-rated money market funds. So you may have knock-on effects such as a lower coupon due to decreased MMF yields or a liquidity squeeze if the MMF faces out-sized redemptions. This is unlike 2008 and 2009, where collateral was tied up in Lehman Brother swap contracts which caused four bonds to defaults.

However, I think there is a healthy pipeline, so when investors are ready, so too will ILS.

David: What impact is climate change having on ILS issuance and ratings?

Jeff: Climate change is unique in that it is a slowly developing issue that occurs over decades, relative to any ILS bond which has a maturity of 3-4 years. There is a duration mismatch where you will really only see climate change affect issuances many years from now. It isn’t today’s or tomorrow’s ILS that will take effect, but rather multi-generational.

Climate change also has a behavioral element. By this, I mean that in spite of the threat, the population will still, for example, desire ocean front property or live in California. Responding to climate change requires new building codes which take time to come into effect.

This causes the exposure risks to increase. Thus, climate change may increase the gap between economic losses caused by catastrophes and insured losses that are actually covered. Will municipalities rise up to the challenge and can ILS be part of the solution?

David: How has ILS affected the role and ratings of reinsurers?

Jeff: The rating impact on the reinsurer universe that we rate has been limited. We do not see ILS affecting the larger ones, such as Munich Re, Swiss Re or Hannover Re. They have such a deep underwriting bench with good communication skills and working relationships that ILS has only a minimal effect on them. In fact, these larger players use ILS to offload risks that they deem unacceptable. ILS may have affected smaller reinsurers years ago, but many of them were bought through mergers and acquisitions.

Interesting, some ILS funds have been acquired by direct insurance writers such as AIG buying AlphaCat and Markel buying Nephila. This serves dual purposes; it allows the direct writers to tap into ILS more directly and allows the ILS manager to get closer to the risk.

In 2019, traditional reinsurers capital grew 9% while ILS fell 2%. This is the first time that reinsurers outpaced ILS. This is attributed to the difficult year that ILS had. There will always be push and tug between ILS and reinsurers, but they each know where they stand and there is healthy competition.


longer-term investors view ILS as a buying opportunity because now they can get into these cat bonds at attractive prices



Investors are facing learning curve when it comes to ILS

2.2 INTERVIEW

David Grana: What is JANA and what is your role in the investment community?

Courtney Wilder: JANA is an independent investment consultant firm based in Australia. We advise on over $600bn in assets across corporate, industry and public sector superannuation funds as well as charities, insurers, foundations and endowment funds. We provide asset allocation, manager due diligence, operational due diligence and governance advice to our clients.

We advise clients in both liquid and illiquid alternative investments, including insurance-linked securities. Within insurance we advise on both non-life and life investments. In non-life reinsurance our clients invest in quota share/side cars, cat bonds and collateralised reinsurance funds covering mainly peak risks caused by natural catastrophes. We also actively recommend investments in life insurance through companies and funds that acquire or reinsure life insurance policies. Whilst we aren’t strong advocates of life settlement funds, we do have clients invested in closed end funds focused on this area.

David: What does the appetite for ILS look like going into the remainder of 2020?

Courtney: Non-life reinsurance has always been difficult to get clients interested in from an investment perspective. Greater acceptance

within investors’ portfolios usually needs to overcome two main obstacles. The first is the terminology and technical language used by the industry. It does not help that the industry has its own language and jargon to describe risk and returns. Most of our clients don’t know what an exceedance curve or rate on line means. The second obstacle is the concept of risk and how its presented to investors. Most of our clients have difficulties conceptualising what a 1 in 50 or 1 in 100-year event means and contrasting this to their risks in their equity or credit portfolios. Being a risk focused driven industry, it also results in all the risks presented upfront and diversification and return benefits displayed thereafter. We find from a behavioural perspective this anchors clients’ to risks they can’t conceptualise and negates the positive attributes of reinsurance in investors’ minds.

Despite these issues, what we’re seeing now is investors considering ILS driven by a need for diversification and low absolute yields in traditional asset classes. Investors we advise usually access non-life ILS via managed funds. We’re seeing appetite in either cat bonds for their relative risk remote profile and liquidity benefits. We are also seeing for our larger investors who need to place larger amounts of money, quota share and side care fund offerings. These investments all carry different risk/return profiles and liquidity. The key is to find a balance of what the client can accept. We direct clients who seek liquidity and lower risk into areas like cat bonds, whereas clients who can take a bit more risk and illiquidity are directed towards the broader reinsurance market. We have seen the latter have more interest up until the first


• Non-life reinsurance has always been difficult to get investors interested in

• Investors will need to overcome the obstacles of terminology and the technical language used in the ILS space

• Rather than uncorrelated, the ILS market is a one-way correlation, whereby catastrophe losses

impact financial markets if the catastrophe is large enough

• Underwriting standards tend to fluctuate depending on whether we’re in a hard or soft market and who has the upper hand in negotiations

Courtney Wilder, Senior Consultant, JANA

SUMMARY




part of this year. Despite the losses over the last two years, it has become a more opportunistic time to get in because of the yields, which have gone up about 50%. Right now, clients are getting a feel and understanding for the asset class before increasing their allocation.

David: What role has climate change and ESG played in ILS?

Courtney: There is a very big focus on ESG and climate change amongst investors in the Australian market. In relation to ILS we see that climate change has a slow-moving impact. Due to annual renewals of contracts and risk based on scientific evidence, we view ILS as an investment that adapts to climate change, very similar to how inflation-linked bonds adapt to changes in inflation. We see ILS investments as one of the rare investments that actively incorporates climate change risks in its pricing and risk assessment.

From an ESG perspective we are seeing a lot of the ILS fund managers acknowledge and start to incorporate ESG practices and polices into their investment process, although compared to equity fund managers they still have some way to go. Incorporation of ESG is undertaken at different levels of the investment process. At the basic level we see managers being active in their underlying collateral that they invest in, focusing on ESG slanted money market funds or IBRD notes offered by the World Bank which support development goals within emerging economies. A lot of the collateral structures of the underlying cat bonds themselves invest in IBRD notes.

More advanced integration of ESG practices we are starting to see managers attempt, and hope will be the standard, involves aggregating and scoring the underlying insurance companies or entities insured within an ILS portfolio. This is a difficult task as it’s not always transparent due to industry data quality.

David: Is this where co-investment can make a difference? Does it give the investor more control and transparency?

Courtney: Yes and no. A cat bond can be issued by a company, an insurance company, or a reinsurance company. If it is from a company, it is very clear who the company is and what they do. When it’s an insurance or reinsurance company, they tend to be multi-line insurers that provide insurance to hundreds or thousands of different companies, which make transparency and aggregation difficult. Co-investment in a reinsurer or insurer may allow for greater underlying transparency so that our clients can see where their pension money is being invested and how it is impacting society. It depends on the underlying data quality of the reinsurer.

David: Because many cat bonds are uncorrelated to financial markets, does this make a logical reason for investors to allocate?

Courtney: We don’t view the insurance market as being uncorrelated. Instead, we view it as one-way correlation. By this, I mean that the impact on financial markets does not impact the insurance market per se, but catastrophe losses do impact financial markets if the catastrophe is large enough. In relation to cat bonds you do see some second order correlation as they are actively traded, relatively liquid investments, that are exposed to mark to market losses caused by investors need for liquidity. For example, right now, in the month of March, you are seeing the price of cat bonds decrease as investors seek to cash out.

In terms of its attractiveness as an asset class, it does provide real diversification in a portfolio that is valuable as part of a total portfolio. While it does provide diversification, it is not a very well-known asset class. It is an industry unto itself with its own language and jargon. There is an education process required, which does take a long time with our clients.

David: Is it possible for underwriting to change because of changes in the bond market?

Courtney: I haven’t heard anything about this at all and would be very doubtful that insurers would adjust their underwriting standards based on what the high yield market is doing. Underwriting standards tend to fluctuate depending on whether we’re in a hard or soft market and who has the upper hand in negotiations. In a hard market, standards tighten benefitting reinsurers whereas in a soft market, there is lots of capital trying to chase insurance deals. This is when the cedents start enforcing looser insurance terms around coverage and exclusions.


It is an industry unto itself with its own language and jargon

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SECTION 3 NEW DEVELOPMENTS

3.1 INTERVIEW

ILS and cat bonds can help investors in achieving their ESG objectives

3.2 INTERVIEW

Will COVID-19 open up the pandemic bond market and will investors be willing to participate?

3.3 INTERVIEW

Hong Kong aims to become hub for ILS issuance



ILS and cat bonds can help investors in achieving their ESG objectives

3.1 INTERVIEW

David Grana: For those unfamiliar with it, what is the history of the Bermuda Stock Exchange?

Greg Wojciechowski: The Bermuda Stock Exchange (BSX) was established in 1971 and is the world’s preeminent fully-electronic, offshore securities exchange. BSX is a full member and sits on the Board of the World Federation of Exchanges, and affiliate member of the International Organization of Securities Commissions. The BSX is also a Designated Offshore Securities Market by the US Securities and Exchange Commission and a Designated Investment Exchange by the UK Financial Conduct Authority, among others.

The BSX also stands to benefit from the new partnership with Miami International Holdings, Inc. (MIH), the parent holding company of the MIAX Exchange Group which acquired a majority ownership of the BSX in late 2019. With this new partnership, the initial focus will be on growing BSX’s existing debt and insurance-linked securities listings by offering a competitive exchange venue as well as enhancing BSX sales and marketing efforts and actively pursuing new opportunities and innovative products.

David: What kind of securities can investors find traded on the Bermuda Stock Exchange?

Greg: As of Q1 2020, BSX has over 1050 listed securities, including investment funds, debt and insurance related securities, as well as

small to medium enterprise companies. BSX’s recent growth is due in large part to its innovative and commercial approach, which includes offering listed issuers speed to market. Many listings take as little as two weeks to complete.

BSX’s is also responsible for the Mezzanine Listing facility, which provides development stage companies with a unique opportunity to list, and subsequently raise capital on an internationally recognized exchange at a much earlier stage than a traditional IPO.

David: Are secondary market participants generally regional or global?

Greg: The majority of issuers are Bermuda-based, but the BSX also has issuers from North America, UK, Europe and Asia.

David: What’s been the history of ILS at BSX and why do you feel that the Exchange is best positioned for the asset class?

Greg: Bermuda remains at the forefront of ILS. In 2010, the total value of ILS listed on the BSX was $1.7 billion. Less than ten years later, by the end of 2019, the total number of ILS securities listed on the BSX stood at 401 for a combined nominal value of $34.72 billion. Given that the global ILS market is $41 billion, this represents 84.68% of the total world market.


• The Bermuda Stock Exchange new partnership with Miami International Holdings, Inc. will focus on growing the existing debt and insurance-linked securities listings

• As of Q1 2020, BSX has over 1050 listed securities, including investment funds, debt and insurance related securities, as well as small to medium enterprise companies

• There has been increasing discussion and acceptance for ILS as a potential Environmental Social and Governance (ESG) investment, especially from pension funds

• Stock exchanges are ideally positioned to assist and improve performance on ESG disclosure

Greg Wojciechowski, Chief Executive Officer, Bermuda Stock Exchange

SUMMARY




The BSX is uniquely positioned to offer issuers of international ILS an affordable, well-regulated and transparent listing venue because of Bermuda’s position as the third largest insurance market in the world behind only London and New York. We refer to the Silicon Valley effect that exists in Bermuda with respect to the specialty insurance industry which has evolved here.

2020 promises to be a transformative year for the ILS market. I feel that this specialization, understanding and commitment to developing exchange services for insurance products has become well known to the market. As a result, the BSX continues to be the listing venue of choice for global ILS vehicles.

David: What is the cross between ESG and ILS, and what is BSX doing to become the global exchange for these types of securities?

Greg: Over the past couple of years, there has been increasing discussion and acceptance for ILS as a potential Environmental Social and Governance (ESG) investment, especially from pension funds. ILS is helping fill the protection gap and provide recovery and resilience.

While not all catastrophe bonds have ESG features, a growing trend is for ILS products to be utilized by governments and companies to increase resilience to macro-level exposures. These solutions could

take a variety of forms, from parametric covers for pandemics, to cyber risk and terrorism, which builds stronger and more resilient economies.

There remains a huge protection gap – $1.2 trillion according to a recent report by Swiss Re Institute – those who are uninsured and underinsured, and ILS is making bold inroads to addressing many of these pressing issues, especially resilience to climate change and natural catastrophic disasters. With the impact of COVID-19, the exposure to pandemic risk will likely draw attention to the global protection gap and solutions like ILS for risk mitigation.

There is also growing appetite for parametric covers such as for drought, flood, pandemic etc. and ILS is an ideal vehicle for helping the developing world recover from natural perils.

The (BSX) last year launched an ESG initiative in line with the World Federation of Exchanges’ sustainability principles (WFE) and is dedicating ESG as a priority in 2020 with the aim to empower sustainable and responsible growth for its member companies, listings and the wider community.

Stock exchanges are at the intersection between capital market participants and their increasing responsibility to ensure business practices are geared towards positive environmental, social and governance practices. This makes them ideally positioned to assist and improve performance on ESG disclosure, so that participants are better able to benefit from the ever-increasing flow of investment being directed towards the sustainable economy. With 250 market infrastructure providers, 48,000 listed companies and $70.2 trillion in equity market capitalization, the WFE members have the size and bandwidth to effect real change in all aspects of ESG.

David: There are other global exchanges trying to break into the ILS market. Why is it becoming such an important asset class for exchanges to be able to offer to investors?

Greg: For the most part, cat bonds covering elemental perils are seeing low-correlation to the financial markets. This is attractive for investors, such as pension funds. Cat bonds and collateralized reinsurance exposures are fully collateralised with low-risk assets, such as cash, US Treasuries and/or Treasury money market funds held in highly-rated banking institutions.

Increasingly, sovereigns are seeking protection. If they can do so through a home market, they may see that as an advantage. Hong Kong is moving forward with enabling legislation for ILS and London has been active in the space. However, Bermuda’s advantage is the depth of expertise and knowledge in this market – as well as critical mass in terms of underwriting, management companies and the BSX as the world’s leading exchange for listing ILS and alternative reinsurance.


FOR THE MOST PART, CAT BONDS COVERING ELEMENTAL PERILS ARE SEEING LOW-CORRELATION TO THE FINANCIAL MARKETS



Will COVID-19 open up the pandemic bond market and will investors be willing to participate?

3.2 INTERVIEW

David Grana: What was the original purpose of the Pandemic Emergency Financing Facility by the International Bank for Reconstruction and Development?

Marcos Alvarez: The Pandemic Emergency Financing Facility was put in place in 2017 by the previous World Bank president. The intention was to transfer the risk of pandemic to the private sector via the alternative insurance market. Pandemic bonds are a sub-category of cat bonds. At that time, issuance was done with the Ebola crisis in Africa in mind. The intent was to help lower income countries, which are part of the International Development Association (IDA), another organization of the World Bank Group, representing around 72 countries, deal with the potential cost of pandemics. Japan, Australia and Germany funded these mechanisms, which the World Bank then placed in the private market.

Features of this Pandemic Emergency Financing Facility include an insurance and a cash window. The cash window has been stopped at this point. The funding for this cash window came from the three aforementioned countries but was exhausted last year after another Ebola breakout in Africa.

The remaining is an insurance window that includes bonds and private swap-type transactions with insurance companies. The swap-type transactions amount to approximately $120 million.

The two other bonds, A and B, were issued for $320 million. They have different risk characteristics, depending on the types of diseases that they cover and how they are triggered. Both are intended to mature in July of this year; however, they can be extended up to one year by the World Bank. Under the current circumstances, it wouldn’t be surprising if they get extended.

David: What are the triggers for these bonds?

Marcos: One of the disadvantages of these instruments is that they are quite complex, each with a 400-page prospectus, and several different triggers. Those triggers include the total number of fatalities and how many countries are affected. Their definition for a global pandemic which is when it affects more than eight countries.

By this definition, we are currently experiencing a global pandemic, regardless of whether or not it has been declared by the World Health Organization. Another trigger is the type of disease that the outbreak covers. In the case of the coronavirus, which is similar to the 2003 SARS outbreak, it’s covered by bonds A and B.

Another interesting trigger, is based on the growth rate of the number of infected cases around the world. The formula from the prospectus is not very simple and there are different definitions the countries affected. To further complicate things, the PEF decided that it would help a specific number of countries which are part of


• Two pandemic bonds were issued for $320 million by the World Bank in 2017

• The bonds have a high coupon of 6-month US LIBOR plus 6.5% for Class A, and 6-month US LIBOR plus 11.1% for Class B

• Because these bonds were privately placed the ratings aren’t public, but they were most likely not investment grade

• These bonds are different from the typical cat bonds because they are highly correlated with the overall financial market

Marcos Alvarez, Senior Vice President, Head of Insurance, DBRS Morningstar

SUMMARY




the IDA. However, when the bonds were underwritten, they included countries that belong to the IDRD and the IDA. The IDA includes the lowest income countries, while the IDRD includes the intermediate developing countries such as Turkey, Mexico and Brazil. Some of the growth calculations are based on this universe, along with the addition of definitions of world-wide territories, which is essentially the entire planet.

For some triggers, they took out the entire planet, while for other triggers, they had a more defined figure based upon IDA or IDRD countries, which results in funds only going to IDA countries. This has created a bit of confusion as to how the bonds are actually triggered.

Another trigger is that the pandemic must last at least 12 weeks, or 84 days, from when the WHO declares an outbreak. Because the WHO acknowledged the outbreak on Dec 31st, this time period has already been met. The only trigger remaining is the growth rate, which is with a calculation agent from a company called AIR Worldwide. If the growth rate remains positive at day 84, or week 12, the bond is triggered. The World Bank first informed on April 9th that the growth rate was still not positive for the first calculation period However, on April 17th, the World Bank reversed course and announced that the independent calculation agent in an updated assessment confirmed that the growth rate was positive, triggering the pandemic bonds and generating a pay out to the PEF for $132.5 million.

David: How were investors compensated for their exposure to these bonds?

Marcos: Both the A and B bonds did have a high coupon of 6-month US LIBOR plus 6.5% for Class A, and 6-month US LIBOR plus 11.1% for Class B. Investors were well-rewarded for their risk.

David: Between the two bonds that were issued, which one is presenting the greater potential risk for investors?

Marcos: The two bonds were issued in different denominations; Class A was for $225 million and Class B was for $95 million. The reason why the Class A pays a lower rate is because it covers fewer diseases, such as the flu and coronavirus, whereas, Class B covers an exhaustive list including flu, coronavirus, fevers, etc.

For coronavirus, 100% of the principal can be impacted on the Class B bond. This means that, if the triggers have all been met, all $95 million could be gone. This is why the bond pays a higher interest rate. If all conditions are met by the Class A bond, the maximum pay-out is 16.65%. This means that, between the two, it would total $135 million if both were triggered to the maximum parameters.

David: Do these bonds have a credit rating?

Marcos: These bonds were privately placed, so the ratings aren’t public. Given the risks that investors assumed three years ago, these bonds were most likely not investment grade. Most cat bonds are not investment grade.

David: What effect would this have on cat bonds in general, and more specifically on these particular types of catastrophes?

Marcos: We feel that these bonds are different from the typical cat bonds, which cover perils such as hurricanes, floods and earthquakes. These pandemic bonds are highly correlated with the overall financial market. They are going to default, at least partially, at the very same moment when markets are hitting lows.

This is very atypical of a cat bond. Institutional investors are attracted to cat bonds because they are less correlated with the overall performance of financial markets. A peril in one country very rarely has an impact on the overall global economy. This pandemic, on the other hand, is a global event. Investors purchasing these types of securities don’t generally like to have that type of exposure.

Besides the current market volatility, I don’t feel that there will be a material impact on the rest of the cat bond market because most of these securities are not correlated with the global financial markets. The cat bond has proved to be an efficient way to transfer risk to the financial market and I feel that this will still continue.

David: Thank you for sharing your views on this topic.

THESE PANDEMIC BONDS ARE HIGHLY CORRELATED WITH THE OVERALL FINANCIAL MARKET



Hong Kong aims to become hub for ILS issuance

3.3 INTERVIEW

David Grana: What are the key points of the Insurance Amendment Bill 2020 with regards to insurance-linked securities?

Mr. Simon Lam: The Insurance (Amendment) Bill 2020 (the Bill) aims to provide for a bespoke, streamlined regulatory framework for establishing Special Purpose Insurers (SPIs) for issuing insurance-linked securities.

The Bill provides that, in order to be authorized by an SPI by the Insurance Authority (IA), a company will need to fulfill the following requirements:

I. it will be fully-funded;

II. it appoints at least two directors and an administrator (who can be a director) who are fit and proper;

III. it carries out only Special Purpose Business as defined in the Bill;

IV. it pays prescribed fees to the IA on a cost-recovery basis; and

V. it complies with relevant financial, solvency, investor’s sophistication and other requirements which may be prescribed in rules made by the IA.

Since ILS are not considered to be financial products suitable for ordinary retail investors, the Bill also empowers the IA to prescribe detailed requirements in rules to confine the sale of ILS to qualified institutional investors.

The IA will continue to engage stakeholders along the ILS value chain in the process of formulating the rules.

David: How does the IA feel that Hong Kong will fit into the landscape of the insurance-linked securities market?

Simon: Given a rising trend of catastrophic events caused by climate change and urbanization, global issuance of ILS has grown substantially in recent years but the risk exposure of such ILS is currently mainly confined to the United States and Europe. There is potential for more ILS transactions with Asia exposure.

Enabling ILS issuance in Hong Kong aligns with the IA’s mission to promote Hong Kong as a global risk management center and a regional insurance hub, particularly in view of the economic development and the increasing risk accumulation of the Guangdong-Hong Kong-Macao Greater Bay Area (GBA) and the Belt and Road Initiative (BRI).

The Central People’s Government announced a series of policy measures in November 2019 on GBA development, including supporting Mainland insurers and municipalities to issue catastrophe bonds in Hong Kong. The Bill will pave way for Hong Kong to become


• Hong Kong’s Insurance Amendment Bill 2020 aims to provide a bespoke, regulatory framework for the issuance of ILS

• There is potential for more ILS transactions with Asia exposure

• As a measure to protect investors, assets of Special Purpose Insurers are required to be invested in very safe and highly liquid assets

• Developing Hong Kong as an ILS domicile is one of the key market development initiatives of the Insurance Authority

Mr. Simon Lam, Executive Director, Insurance Authority of Hong Kong

SUMMARY




the preferred domicile for ILS, in particular catastrophe bonds, thereby helping insurers better capture business opportunities. More importantly, it will help extend the capacity of the insurance industry, thus enhancing its sustainable development.

As for the BRI, these projects are exposed to complex and exotic risks, for which Hong Kong is in an ideal position to provide effective risk management services and insurance solutions. The issuance of ILS in Hong Kong would provide an additional tool for Mainland enterprises participating in BRI to enhance their risk management mechanism. Functioning like an offshore financial center within the national boundary, and as the largest offshore RMB center, Hong Kong is eminently suitable for Mainland enterprises to manage insurance and currency risks associated with their investment in BRI territories.

David: Does the IA intend to open the Hong Kong ILS market to regional institutional investors, or is the objective also to attract international investors?

Simon: We welcome all qualified institutional investors, whether regional or international, to invest in the Hong Kong ILS market, seizing opportunities arising from the GBA development and the BRI.

David: What provisions will the IA take to ensure that insurers are well-capitalized to issue ILS, and that investors are protected?

Simon: An ILS, by its nature, is fully funded/collateralized so it is bankruptcy remote. However, the IA expects the insurer sponsoring the ILS, whether authorized in Hong Kong or elsewhere, to be professional and financially sound. In that regard, the authorization and regulatory regime would put strong emphasis on the corporate governance, and “fitness and properness of the sponsor, directors and administrators of the SPI.

As a measure to protect investors, assets of the SPI are required to be invested in very safe and highly liquid assets, such as government securities and held under trust for repayment to investors after discharging insurance liabilities.

In addition, investment in ILS is open only to qualified institutional investors who have sufficient expertise to conduct their own due diligence. As such, ILS is not considered to be financial products suitable for ordinary retail investors, so the Bill also empowers the IA

to prescribe detailed requirements in rules to confine the sale of ILS to qualified institutional investors.

David: What is the timeline for Hong Kong to begin allowing the issuance of ILS?

Simon: The Bill was gazetted in March pending further vetting of the Legislative Council. We look forward to the commencement of scrutiny process by the Legislative Council as soon as practicable, and the IA will render full support throughout. In parallel, the IA will work on the draft rules and other preparatory work in consultation with relevant stakeholders, with a view to enabling the issuance of ILS shortly after passage of the Bill.

The foregoing complements other legislative changes such as:

• An amendment bill seeking to expand the scope of insurable risks for captives to cover the underwriting of risks of bodies corporate within the group and the underwriting of scaled interest risks in proportion to the controls over the relevant body corporate by the group etc. is also awaiting scrutiny by LegCo. By expanding the scope of insurable risks by captive insurers, multinationals will be able to implement their global risk management strategy more effectively to cover their projects;

• A tax amendment bill seeking to cut by half the profits tax rate to 8.25% for insurers underwriting marine and specialty (e.g. catastrophe, political, terrorism, war and credit) risks. The tax concession is also applicable to insurance broker companies placing such risks to (re)insurers in Hong Kong.

Developing Hong Kong as an ILS domicile is one of the key market development initiatives of the IA. It is also an important supporting pillar to the building up of Hong Kong into a regional (re)insurance hub and global risk management center.

David: Thank you for sharing your views on this topic.

Functioning like an offshore financial center within the national boundary, and as the largest offshore RMB center, Hong Kong is eminently suitable

for Mainland enterprises to manage insurance and currency risks associated with their investment in BRI territories

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