ILS emerges as an alternative asset class
Fiona Le Poidevin (pictured), chief executive of Guernsey Finance, explores how Guernsey’s investment and insurance expertise mean it is capitalising on the opportunities presented by the growth of Insurance Linked Securities (ILS).
Insurance Linked Securities (ILS) are growing in popularity among investors as an alternative asset class and with insurers as a means of accessing greater quantities of affordable risk transfer capacity. ILS permit an insurer 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 or collateralised reinsurance. Investors are increasingly attracted to ILS because returns are non-correlated with the general financial markets.
What are insurance linked securities (ILS)?
Standard and Poor’s says that they “are instruments through which insurance risk is transferred in a capital markets contract.” ILS are increasingly used to finance peak, non-recurrent insurance risks, such as hurricanes and earthquakes and other similar types of losses. ILS are significant because they are offered direct to the capital markets, which expands risk bearing capacity. For investors, this represents a unique asset class which is uncorrelated with the general financial markets.
Fitch Ratings’ Alternative Reinsurance 2013 Market Update: Convergence Here to Stay (published on September 3rd) states that the demand for alternative reinsurance instruments is set to continue. This is due to the comparatively high potential returns of catastrophe risk through cat bonds and sidecar investments and the lack of correlation between catastrophe losses and returns on other major asset classes. Brian Schneider, co-head of reinsurance at Fitch Ratings, notes: “The convergence of the reinsurance and capital markets is likely here to stay and should continue to grow in the near term.”
This is backed up by a report from Aon Benfield Securities, whose recent paper Insurance Linked Securities: Capital Revolution – ILS Market Expands to New Heights, published on August 30th this year, shows that in the 12 months to the end of June 2013, “the ILS market received record capital inflows from both new and existing investors.” Strong investor demand for insurance risks has resulted in more competitive ILS pricing in comparison to the traditional reinsurance product, which in turn has encouraged sponsors to bring more issuances to market.
Specialist cat funds remain the largest part of the ILS investor base, although they, along with hedge funds and reinsurers, have trimmed their investment in new ILS issuance during the last year. However, institutional investors remain a large and growing proportion, and mutual fund participation is up, with the report commenting that “we still see mutual funds as a future source for increased direct participation in the ILS sector.”
The demand from investors for increased allocation into ILS is putting pressure on asset managers to ensure that they have the capabilities to meet this need. What we are seeing is that a growing number are turning towards Guernsey to establish investment structures which offer exposure to ILS.
ILS: market convergence
Guernsey’s great strength is that it has a long and strong heritage in both the investment funds and insurance sectors. As such, it acts as a centre where fund managers and promoters with capital to deploy are brought together with the transformation managers who understand insurance risk.
The Island has a well-established investment sector where the net asset value of funds under management and administration stands at GBP286bn. This comprises a wide range of investments, including alternative and esoteric asset classes, such as ILS.
For example, the Guernsey domiciled DCG Iris Fund has been established as a closed-ended feeder fund into the Low Volatility Plus Fund managed by Credit Suisse Asset Management’s ILS team. Dexion Capital initially fundraised over GBP60m for the fund which is listed on the Main Market of the London Stock
Guernsey is the global leader for non-UK listed entities on the LSE. Vehicles established in the Island can also access other global capital markets, including the exchanges in Frankfurt, Ireland, Toronto, Australia, Hong Kong and Euronext, among many others, as well as the Channel Islands Stock Exchange (CISX) which is based in Guernsey.
In fact, in 2012, the CISX became home to the first private catastrophe bond listed on any exchange worldwide. Aon Insurance Managers in Guernsey—which has been involved with more than 80 ILS transactions since 2006—has worked with Swiss ILS manager Solidum Partners AG to establish Solidum Re Eiger IC Limited.
It is an insurance vehicle which listed bonds with a value of $52.5m on the CISX. It was the first CISX listing where natural catastrophe perils are the underlying exposure for ‘principal at risk’ notes and incorporated a dual listing with the Vienna Stock Exchange.
The legal advice for the transaction was provided by Bedell Cristin in Guernsey. Mark Helyar, Managing Partner, who completed the listing, said: “Guernsey and the CISX are ideally placed to support this business because of the specialist insurance and professional sectors able to provide a high quality, transparent marketplace for securitising catastrophe risk in a well regulated and respected jurisdiction.”
Cedric Edmonds, Partner at Solidum Partners and Director of Solidum Re Eiger IC Limited, said: “Solidum Partners chose Guernsey as a jurisdiction for its incorporated cell reinsurance company and private cat bond platform due to the Incorporated Cell Company legislation and the quality and ‘can do’ attitude of the service providers.”
The growth in ILS business within Guernsey is demonstrated by the fact that it is proving a significant factor behind the continued increase in the number of international insurance entities domiciled in the Island. There were nearly 100 international insurance entities licensed in Guernsey during 2012 alone and this growth has continued during 2013, with the net number of entities up 37 to reach a total of 774 at the end of July 2013.
A large number of the new entities being established are Protected Cell Companies (PCCs), Incorporated Cell Companies (ICCs) or related cells.
PCC and ICC structures provide a low cost, low administration vehicle to access returns from the reinsurance market and some ILS funds avail themselves of both within their growth strategies.
At the time of writing, there are in excess of 50 protected cells established in Guernsey across four different PCC platforms having written fully collateralised reinsurance primarily covering property catastrophe risks, marine, crop and other classes such as premium reinstatement or prize indemnity. Protected cells in Guernsey are also being used to conclude International Swaps and Derivatives Association (ISDA) arrangements as an alternative to a reinsurance contract.
For ILS funds which prefer not to co-mingle their assets in one third party sponsored PCC, a dedicated PCC provides the security of a standalone, ring-fenced entity set up solely for the use of one ILS fund with the convenience of segregated cells for each separate transaction. There is flexibility in the type of reinsurance contract being entered into by each PC, provided that the cell is fully funded up to its maximum aggregate exposure by a combination of contract premium and investment funding injected by the ILS fund.
Creating a separate IC within an existing ICC structure or creating a standalone ICC company owned by an ILS fund has the benefits of providing lower establishment and running costs with complete legal segregation of assets and liabilities. A principal benefit for the ICC structure is managing counter-party risk.
Some ILS funds are limited as to how much capital can be invested witha single incorporated vehicle. As the PCC structure is a single corporate entity (despite the robust segregation of assets and liabilities within individual cells) this credit limit can be quickly exceeded. However, the ICC structure reduces the counter-party credit risk measurement to each cell allowing much larger aggregate relationships to be built under the direction of a single board. Guernsey has a significant advantage over the competition in that it not only offers the PCC – which was pioneered in the Island – but also the ICC. Indeed, there is significant experience and expertise in utilising these structures across both the insurance and investment fund sectors in Guernsey.
Guernsey’s greatest differentiator is that it is a jurisdiction with a leading investment funds sector as well as a world-leading insurance industry and as such, it is therefore no surprise that the Island is already home to increasing amounts of ILS business.
Guernsey offers the advantage of being politically and economically stable with no external Government borrowings. Its proximity to London and position in the UK time zone mean it is very well placed for interaction between the European and US markets. It also has a temperate climate and is not prone to significant natural disasters. These factors continue to serve Guernsey well in its evolution as a leading International Finance Centre (IFC) and in particular, as a growing hub for ILS business. However, the financial services infrastructure and expertise which have been fostered over more than 50 years are also key ingredients to the Island’s proposition for ILS.
Indeed, a significant strength of Guernsey is that it can demonstrate substance already being present in existing structures. Both leading fund and insurance managers have offices and staff present in Guernsey and there is a large pool of qualified Non-Executive Directors (NEDs) experienced in providing management functions.
They are supported by multi-jurisdictional law firms and global accountancy firms as well as administrators ranging from the major multinational organisations to independent, boutique providers.
Furthermore, the existence of 32 licensed banks means that a wide range of services are also on hand, including custodian functions and access to very competitive letters of credit.
In addition, Guernsey can also boast that it is widely respected for meeting leading international standards in terms of financial services regulation and tax matters: the Island was within the very first wave of jurisdictions placed on the OECD ‘white list’ for tax transparency and exchange of information; and the IMF has judged it to have a higher level of compliance with Financial Action Task Force (FATF) standards for financial services regulation than any other jurisdiction globally.
Yet, Guernsey is also keen to ensure that its supervision is not just robust but also pragmatic and as such, there is a focus on also ensuring that regulation is proportionate and speedy. For example, it offers a fast-track facility to the Specialist Fund Market of the LSE.
The right conclusion
There are a number of outstanding factors which mean that Guernsey provides a unique proposition as a hub for ILS business. This is already being recognised by many in the market and we expect that this growth will continue as increasing numbers of fund managers seek to satisfy the demand from investors for the diversified and uncorrelated returns provided by ILS.
Originally published in FTSE Global Markets, October 2013.
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