The Intelligent Quarterly from the publishers of The Insurance Insider

Summer 2013

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Generalist investors such as hedge funds and institutional investors are becoming more active in the insurance-linked securities (ILS) market as they seek yield in today's low-rate environment. But it appears that specialist cat fund investors are also benefitting from this increased interest.

John Seo, founder of leading ILS investor Fermat Capital, estimates that the convergence market has taken $3bn to $4bn of new fund inflows in recent months from investors disenchanted with low returns from safe haven investments.

One of the factors drawing in such investors is a spike in the number of high-rate, high-risk deals brought to the cat bond market over the past six months.

Aon Benfield Securities estimates that hedge funds and institutional investors bought nearly half (47 percent) of the cat bonds it placed over the course of 2011 and going into the first quarter of 2012, compared to just over a third (36 percent) in 2010 (see graph).

"There's a definite rebalancing of investor types over the past year or so," says Aon Benfield Securities CEO Paul Schultz. "We see capital coming in across the board."

Hedge funds still played a relatively small role but their growth in market share was the most significant - jumping from a 4 percent share of deals placed by the broker to taking 13 percent. Schultz says hedge funds were also active in the collateralised private markets last year.

In addition, Deutsche Bank director Michael Halsband told Trading Risk that he had noted strong interest from multi-strategy hedge funds and other non-specialist investors - many of whom had not been in the market since 2004/2005 - as ILS yields compared favourably with other instruments.

So what do generalist investors bring to the market and will their increased participation change its shape?

Growing maturity
Oppenheimer Funds' senior portfolio manager, Caleb Wong, says that generalist investors benefit from being much more attuned to the relative valuations of ILS within the broader capital markets than a dedicated investor.

Within the ILS universe there are some bonds that have greater correlation to market forces than others, he warns - such as Japan earthquake and extreme mortality risk - even though the dedicated managers might regard these bonds as sought-after diversifiers. Click to enlarge

This also creates a somewhat counterintuitive scenario where dedicated ILS managers are less concerned about concentration in their portfolios than a generalist investor, because specialist funds are only being benchmarked within their universe, Wong adds.

And if more institutional investors or hedge funds were to start investing directly this could shape the appearance of the sector, as they tend to have different targets, says Ryan Bisch, Mercer's director of exotic alternatives. "It could influence where the sectors of growth are," he explains.

But Bisch says it is not yet obvious that there has been any significant rise in interest from mainstream investors. "There are other attractive options at the moment, such as distressed debt... it becomes a higher hurdle for making the case to continue to invest in ILS," he says. "We are not in an environment like post-Katrina where everyone is talking about the sector."

What then, besides another Katrina, would it take to attract more investors? Early entrants such as Oppenheimer have benefited from being a market pioneer, Wong says, because the sector's small scale is a limiting factor for institutional investors.

But nonetheless, he says there is more room for his peers. "What we need to see is continuing maturation of the insurance market."

Schultz agrees that success would beget growth. "There's a general sense that the market is growing; that tends to bring in new investors."

Sunshine state deal
Meanwhile, the cat bond market has concluded a landmark deal on the back of resurging interest in ILS from generalist investors. A bumper $750mn issuance issued by Florida state-backed insurer Citizens closed in May as the largest ever single-tranche bond to emerge from the market.

Only the $1.059bn Merna Re bond, issued by State Farm in 2007, is larger, but this included multiple tranches of different risk levels. Click to enlarge

The Everglades Re bond provides Citizens with indemnity reinsurance cover against a hurricane strike on the Florida coast - the single largest concentration of risk in the (re)insurance markets.

Citizens had initially set a much more modest $200mn-$250mn target for the deal, but the response from investors allowed it to significantly increase the purchase.

Everglades Re offered ILS investors a juicy insurance-related coupon of 17.75 percent - attracting a greater proportion of generalist investors than a typical ILS placement.

More than half the Everglades Re bond was placed with specialist cat fund investors, but some 25 -30 percent went to hedge fund investors seeking yield and diversification, according to Goldman Sachs managing director Shiv Kumar.

Kumar says that many of the investors were new to the ILS market or general investors that had not been active cat bond buyers for years. Correspondingly, reinsurers had a low involvement in the deal - making up less than 10 percent of the distribution list.

Clean structure
The Citizens deal appealed because it was "cleanly and robustly structured", Kumar adds, while Citizens welcomed the diversity that the cat bond purchase provided within its risk transfer programme.

"This brings to Citizens a significant increase in the diversification and capacity of risk transfer resources, while not adversely affecting the availability of risk transfer for the private Florida insurers," said the insurer's chief financial officer, Sharon Binnun.

Everglades is one of a growing number of ILS bought by state government entities in recent years, providing peak zone cover for single state risk (see table).

One source told Trading Risk that the Everglades Re bond was a "validation of the asset class", which he argues was established to take exactly the kind of peak peril risk that Citizens needs to hedge. "This is what we're about - taking the top off the peak perils at a cheaper rate than rated reinsurers can," they said.

Kumar adds that Everglades did not indicate any shift in power towards the collateralised segment in a hardening property cat market.

"It reflects the expansion of the market rather than any shift from one supplier to another," Kumar says. "There is an increasing overlap between the two subsets of the reinsurance markets."