Within the capital markets, there remain a large number of institutional investors seeking out unique opportunities in alternative investments. One such area is insurance-linked securities (ILS), which have built significant traction since the 2008 financial crash.
Estera has been providing corporate, trust, fund and accounting services for over 25 years and has carved out a leading position in the support of ILS products. Analysis of its book of business over the last 10 years shows that the market capitalisation of ILS products it supports has grown from approximately USD2 billion in 2011 to USD10.8 billion at the end of 2016. Last year, the total market capitalisation of Estera’s ILS clients grew 20 per cent to USD12.9 billion and there are signs that this growth trend is set to continue.
“One of the reasons for this is that ILS is not correlated to the broader stock markets; whether the stock markets go up and down has no direct impact on the pricing of ILS,” says Sherman Taylor, Associate Director at Estera. “The only thing that could impact an ILS investment is if a covered loss event legitimately attaches to the collateral.
“One of the things we’ve seen from a historical standpoint is that the loss experience has been good. In 2017, there was a covered loss event after the earthquake in Mexico that attached to one tranche of the IBRD/Foden 2017 Cat Bond. The positive thing that came out of that event for the ILS industry was the orderly way that it responded, with the Cat Bond paying out USD150 million to the Mexican government.”
The earthquake that Taylor refers to was a 7.1 magnitude event that hit Mexico on 19th September, 2017. It is estimated to have caused as much as USD4.8 billion of losses to insurance and reinsurance interests.
“When it came to the January 2018 insurance/reinsurance renewal period, there was some concern that the catastrophe events of 2017, including the Mexican earthquake and several major hurricanes, might have an impact on the ILS market by dampening interest from the capital markets. However, that proved not to be the case. The response of the ILS industry to the 2017 catastrophe events instead gave the capital markets additional confidence in ILS investments because, with each of those events, the system worked precisely as expected to determine whether there were any insured losses attached to ILS capital,” explains Taylor.
Recent market data from the Bermuda Stock Exchange (BSX) shows that 2017 was another growth year for Bermuda’s ILS market, with 103 new ILS products coming to market during the year with total nominal value of USD11.54 billion.
Estera acted in various roles for 60 per cent of those new products, representing total nominal market value of USD5.8 billion, underscoring its position at the forefront of this asset class.
Far from being scared off by the loss event, the capital markets stepped up to the plate, with hedge funds and other investors continuing to allocate into the asset class, satisfied that, if ever there was a loss event potentially impacting their investment, there will be an orderly resolution, consistent with the transaction documentation, and without any need for arbitration in the courts.
“It is testament to the ILS asset class,” says Sarah Demerling, Client Director, Estera. “We have watched it evolve since its infancy. Investors’ level of understanding of the ILS space today is much deeper and it shows how resilient the asset class is. Investors reacted very well to the recent loss events, it was a very orderly approach and in short, it did exactly what it is supposed to do on the ‘tin’. Because of the hurricanes last year, there is always a chance you are going to incur losses. One might have thought that investors would run for the hills but the opposite was true.
“The outlook for 2018 is strong, in that sense. Pensions, SWFs are becoming more comfortable and giving a larger allocation of their portfolio to the ILS space.”
This is further helped by the fact that ILS structures continue to evolve. Demerling notes that whereas before the space was dominated by heavily regulated Cat Bonds, “we now see a move towards more Cat Bond-lite structures”.
‘Cat Bond-lite’ is a concept developed out of a desire to bring smaller sized ILS, typically less than USD50 million, to market more quickly. These securities are generally brought to the market via private placements. “It is a further commoditisation of the ILS product and a good fit for Bermuda, often making use of Bermuda’s segregated accounts company capability, together with its special purpose insurer capability,” adds Demerling
Bermuda is uniquely placed to support this asset class given its long-standing reputation in both the insurance world and the investment world. It has the right talent in place to support these two areas of the market in terms of legal, accounting, insurance professionals, audit, trust administration and so on. “A lot of the main players who are active in the ILS industry already have a strong presence in Bermuda and have done so for a while,” confirms Taylor.
He adds that because of the experience and reputation the BSX has in the industry, it attracts a lot of ILS deals, which typically require a listing on a recognised stock exchange. At the end of 2017, USD26 billion of ILS capital was listed on the BSX.
This is helped by the fact that Bermuda’s regulation has developed in a way that reflects the sophistication of the ILS market. Back in 2009, the Bermuda Monetary Authority made amendments to the Insurance Act 1978 by introducing a new class of “Special Purpose Insurer” (SPI), which enjoys a lighter touch regulatory regime.
“It was well thought out. The minimum capital requirement for an SPI is just USD1,” says Demerling. Moreover, there are no investment restrictions and the operator of an SPI can waive the need to have an audit. This makes the SPI the perfect vehicle for issuing ILS.
“In addition, we have Segregated Accounts Companies (SAC’s) legislation so the right structures were put in place to encourage the ILS market to flourish,” says Demerling.
SACs are commonly used for a variety of insurance purposes, including rent-a-captives, life and annuity companies, transformer vehicles, as well as financial guarantee, securitisation and derivatives structures and special purpose vehicles.
One interesting trend that is beginning to emerge is the creation of a secondary market for ILS products, with some early signs that platforms are being developed to facilitate underlying derivative-type transactions. The upshot to this is that it could create more liquidity in the ILS market, as has been happening in PE secondaries over the past few years.
“Traditionally this type of instrument has been held to maturity. Now we are seeing investors wishing to move pieces of ILS from one sub-fund to another. There is a lot of talk about creating more liquidity and it will definitely take ILS into a whole new realm. It could create a whole new class of investors who don’t necessarily want to hold these investments to maturity,” confirms Taylor.
Demerling concludes: “Given where we are in terms of generational shift, we might also start to see more socially responsible investing coming in to the asset class.”