The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2018

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The strongest link?

William Dubinsky

Trading and liquidity are imperative to growing the insurance-linked securities (ILS) market and delivering competitive pricing and terms for reinsurance backed by ILS. Yet ILS trading is typically not well understood, except by market insiders.

ILS proceeds provide collateral to back reinsurance contracts. Traditional reinsurance balance sheets are also backed by securities including the surplus notes of a mutual or the common equity of a reinsurer. What is different with ILS is the "linked" part.

ILS is typically linked to the performance of a specific reinsurance contract rather than the performance of the entity as a whole. This means that when ILS trades, the traded value in part reflects the value of the associated contract. If the contract pays a claim because of a hurricane, the linked hurricane ILS drops in value.

Basic ILS structure
Stepping back, it is important to understand a typical ILS set-up. The most important thing to know is that an ILS deal is not one transaction but two, as shown in the diagram.

This is the case regardless of whether the risk transfer is proportional or non-proportional and regardless of whether the deal has a single investor or multiple investors. For convenience, we call the single investor deals where the investors might purchase a security from a segregated account in a segregated account company "collateralised re" and the multiple investor transactions "catastrophe bonds".

Nonetheless, both single and multiple investor ILS deals follow this same basic pattern because the investors are not licensed reinsurers and cannot write "collateralised re" directly from a regulatory standpoint. They can only make investments and cannot bind reinsurance contracts. A transforming reinsurer must sit in the middle if the ceding company seeks legal form reinsurance.

While this set-up covers most situations, the range of potential structures is vast. For example, some corporates will transact via derivative rather than by insurance or reinsurance of a captive. In other situations, entities besides the transforming reinsurer provide fronting services so the protection buyer faces a rated and regulated "promise to pay" insurer or reinsurer.

There have also been a number of attempts to establish exchange-traded contracts, albeit with limited success. As ILS grows in importance, these and other structures could become increasingly important.

Why does ILS trading matter?
Do ILS investors value liquidity? The short answer is yes. And they do so for several reasons.

Firstly, some of the investors themselves need liquidity. For example, a specialist ILS fund may need to fund redemptions or want the flexibility to change their ILS investment mix over time. With an illiquid investment, their capital is trapped until released. With a liquid investment, they can sell and then redeploy the cash as necessary.

Other investors require liquidity such as European UCITS funds (Undertakings for Collective Investment in Transferable Securities - essentially a type of mutual fund).

Liquid ILS also facilitates leverage on the investor side by allowing investors to effectively borrow against the value of their positions. This is similar to an individual investor buying common stock of a public company on margin.

Here, the ceding company is no more impacted by the borrowing than the public company would be in the stock margin situation. As with ILS trading, the ceding company's rights and obligations are essentially unaffected by leverage on the investor side.

Consider loss development following an earthquake. With liquid ILS, an investor may be able to exit a position with a loss. With illiquid ILS, the investor's capital may be trapped regardless of whether a loss ultimately occurs. In contrast with traditional reinsurance, only the balance sheet is "trapped" and the risk is shared with the ceding company.

Secondly, traded products are easier to value accurately. Where trading occurs, the trading price provides a quantifiable indication of value - something more difficult to come by with either illiquid ILS or traditional reinsurance. Investors also receive price indications on a periodic basis from securities broker-dealers, reflecting the current market valuations of liquid ILS through so called "pricing sheets".

Liquid ILS trading enhances price discovery more generally. A traditional reinsurance contract may only renew once a year but trading of related ILS can inform potential renewal pricing by providing an early warning of any forthcoming price drops or rises.

Price indications for liquid ILS can also supplement "mark-to-model" valuations for illiquid ILS with similar characteristics. Even end investors who do not need access to cash want accurate valuations on illiquid ILS from their ILS funds.

How much trading occurs?
Today, we estimate there is about $75bn of non-life ILS capital. Of this, about one-third is in the most liquid form of ILS, catastrophe bonds. A rapidly growing portion, but still under $5bn, is in ILS of intermediate liquidity. In these cases, trading is possible but more difficult and with fewer potential buyers.

Click to enlarge The remaining ILS investments are illiquid. In recent years, the market share for illiquid ILS has grown quite a bit. However, in the second half of 2016 this trend began to reverse.

Illiquid ILS grew because liquid ILS involves extra costs to create the liquidity. These include out-of-pocket costs to arrange the deal as well as some different requirements in ongoing transaction management.

Where these costs outweigh the benefits, illiquid ILS done on a single investor basis, with or without fronting, provides an easy-to-execute alternative.

Even with liquid ILS, many investors take mainly a buy-and-hold approach, so the total amount of trading without a catalysing event such as a large hurricane or a financial market meltdown is modest compared with many other fixed income markets.

That said, the margins broker-dealers charge for trading are modest versus other similar asset classes and there are a healthy number of broker-dealers that intermediate ILS. As such, practical liquidity is very good, as reflected in our experience, as well as the limited data available from the Financial Industry Regulatory Authority's Trace (Trade Reporting and Compliance Engine) system.

Furthermore, large reinsurers can invest in ILS and, as a group, effectively provide a backstop on the market as natural investors of last resort. This may partially explain the resiliency of liquid ILS in the face of the Long-Term Capital Management meltdown in 1998 as well as the financial crisis 10 years later and in other periods of volatility, both financial and reinsurance-related.

We anticipate liquid ILS and trading will remain important and that ILS of intermediate liquidity will continue to evolve. For the foreseeable future both liquid and illiquid ILS will coexist.

As ILS trading becomes more efficient and ceding companies and others more comfortable with ILS liquidity, ILS capacity will become an even more important source of capital for the industry.

William Dubinsky is managing director and head of ILS at Willis Capital Markets & Advisory.

This article was published as part of issue Spring 2017

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