A parallel universe

While the use of insurance-linked securities (ILS) continues to grow steadily as a risk transfer mechanism, some believe the key to its long-term success and continued growth is the creation of a deeper secondary market for trading this type of risk.

A larger secondary market would likely encourage new investors and bring a level and depth currently unavailable.

James Slaughter, senior vice president and director of global reinsurance strategy at Liberty Mutual, says that broadening the secondary market would not only encourage new types of investors to move into the space as ILS becomes easier to trade, but it would also create a much more liquid space for them to move into and out of freely.

“In the current market it is likely that this will just fuel an arbitrage market rather than provide long-term advantages to buyers.” James Slaughter

However, he adds, such a situation would be unlikely to provide long-term advantages, such as lower pricing, to buyers.

“From a general market perspective a secondary market should provide some of the following benefits: price discovery, liquidity to reinsurers to manage portfolios and a market for ‘alternative’ capital to deploy its assets to achieve their aims without diluting the small primary market,” he says.

“However in the current market it is likely that this will just fuel an arbitrage market rather than provide long-term advantages to buyers. At the moment there is simply a surplus of capital and if it can find quick and easy ways to deploy, then it will seek those opportunities.

“As a buyer anything that works to improve access to cost-effective sources of appropriate capital is welcome, but from a legal and regulatory perspective the secondary market is unlikely going to be a market for buyers that make a capital market for the sellers of reinsurance.”

Leveraging the difference

Martin Davies, chief executive at AHJ Capital Markets, explains that it is the existence of the secondary markets available in this asset class which distinguishes the ILS product from more conventional collateralised reinsurance.

By embedding the reinsurance risk into a tradable security, the product can be bought and sold, which in turn allows it to be objectively valued. In turn, this should generate increased liquidity and increase the market’s appeal to investors.

“When an ILS is created, the investors buy a security, the returns of which reflect the results of an underlying reinsurance contract,” he says. “Investors have the option of keeping the security and the returns they hope it will deliver or they can sell it during the period they own it. It is this subsequent sale that creates the secondary market.”

But while some bemoan the liquidity available, others argue that it is already robust. Rick Miller, co-head of ILS at Jardine Lloyd Thompson Capital Markets, says that liquidity and secondary market trading is strong and healthy.

“For a high yield bond market, I would describe the secondary market liquidity in the ILS space as nothing short of phenomenal. If you’re a buy side investor, the bid/offer differential is around 15 to 20 cents, versus 50 to 150 cents in other high yield asset classes.

“Admittedly you’re talking about short-term duration—one to three years—but liquidity and secondary market trading is quite strong and healthy,” he says.

Record levels of issuance in the primary ILS market in 2014 demonstrated the growing strength of this type of risk transfer. The year was characterised by a number of records including the industry’s largest ever catastrophe bond, which closed at $1.5 billion last year.

Offering an uncorrelated return from the rest of the economy, investors are increasingly attracted to ILS as a form of risk transfer.

So, as the primary market grows, so too does the secondary market, increasing trading and the option for an investor to “change his mind”—something which, Davies says, is a valuable asset.

“The great advantage of a tradable investment over an illiquid assumption of risk is that the risk-taking investor is able to change its mind and adjust its position accordingly. An investor may believe that the market is not pricing the risk correctly, for example,” he says.

“Perhaps the initial price did not reflect fully the demand that existed for it. Maybe there are other investors with a more optimistic view of the risk of loss—especially once significant weather events occur. Or more attractive issues, which create a better diversification for the initial investor, may have come onto the market.”

Referencing Ron Dembo and Andrew Freeman’s book Seeing Tomorrow (1998), Davies explains a simple concept which can be applied to the freedom associated within ILS transactions.

“I would describe the secondary market liquidity in the ILS space as nothing short of phenomenal.” Rick Miller

“If you can easily and quickly trade out of a position you will not feel (much) regret if it starts falling in value. If, however, you are stuck with a risk, you may well feel a lot of regret. This concept indirectly allows us to assign a monetary value to being able to trade,” he says.

Miller says: “From a portfolio manager’s perspective, their book is dynamic and their views might change based on pricing, so they want to know that they have the ability to trade in and out of their positions. It gives them more comfort around liquidity around the marketplace.”

Another benefit of the secondary market is the ability to release collateral. While conventional collateralised reinsurance places the risk taker’s collateral into a trust account—meaning that new collateral must be found in order to take on new risks—once an ILS is traded, the collateral requirement then lies with the new investor.

Treading new ground

The secondary market is currently small and underdeveloped in contrast to the primary side of the market. However, as more perils flood into the sector, new investors will come, allowing trading in the secondary market to grow.

“There’s only so much supply in the marketplace, so what you see is people trading to move around their overall position,” says Michael Popkin, managing director, co-head of ILS at JLT Capital Markets.

“The imbalance isn’t that there isn’t interest in the secondary market, it’s just that we need more risk brought in.”

Miller agrees: “The infrastructure built around the market is robust and available to absorb more products easily and the investor base is appropriately deep and sophisticated enough.”

Increased trading will offer many benefits to the reinsurance industry, such as a more detailed view of appropriate pricing.

Davies adds: “If a true secondary market develops, it will generate a price discount for the liquid ILS versus the illiquid standard reinsurance contract. To some extent this already exists: many ILS funds are required to invest only in issues that can be traded and where there is a market price. Consequently, there is more demand for such securities and the price is driven down.”

Popkin says that the pricing around secondary levels provides some guidance around where the price per risk is, which is visible to reinsurers and ILS managers, which is helpful and informative.

“If you’re a traditional market user and you’re coming to market once a year for your programme placement, and you’re able to observe intra-year where prices are moving, it’s going to give you some idea around what is the multiple required for a particular expected loss, given the mixture of perils.

“It’s providing market information about what the current yield requirement is for a given level of risk on a more frequent basis, so it is informative,” he says.

“A more radical effect of secondary trading is that it can encourage more complex trading strategies that are driven by price volatility.” Martin Davies

Miller adds: “As a traditional reinsurance player, you probably already have visibility on the capital markets’ view of risk. This may come from viewing things externally as an issuer of bonds. It may come from the perspective of a third party asset manager operating off your traditional reinsurance platform and running a portfolio of bonds. It’s helpful in terms of monitoring that because it will give you a directional perspective on a more granular level of where rates are going.”

Davies agrees. “Information gained from the secondary market tells us what the market thinks each ILS is worth at every point in its existence,” he says. “A new security being traded at a premium—or a discount—tells us how effectively it was marketed and how we should approach the renewal.

“The market pricing of similar securities tells us better than any individual underwriter what the correct price for a risk should be if it is to be placed efficiently. This creates a feedback loop where secondary pricing drives primary underwriting.”

Davies also comments on the potential to introduce a more complex way of trading, which incorporates both ‘short’ and ‘long’ positions.

“A more radical effect of secondary trading is that it can encourage more complex trading strategies that are driven by price volatility. Currently, investors usually adopt a ‘long only’ strategy in that they buy and then hold their investments.

“A liquid secondary market allows both long and short positions to be taken—and then reversed as desired. Many other markets are driven by ‘basis trades’ where commodities or financial instruments are bought and sold for different time periods.

“In reinsurance terms, one might, during 2015, enter and exit a trade that bought reinsurance for 2016 and sold it for 2017, to exploit the expectation of relative price change. The speculator would never go ‘on risk’ in an insurance sense—it would merely be exposed to adverse price movements,” he says.

Slaughter agrees. “There will undoubtedly be development in product around term, structure and operation. It wouldn’t be a stretch to foresee a derivative market, which would open up a host of hedging, speculative and bespoke structuring opportunities, emerge if there was sufficient liquidity,” he says.

“However, and as always with insurance risk, a cautionary approach is probably appropriate as markets need to learn to deal with the complex nature of the underlying loss (timing of cash flows, impact of disputes, reporting time frames, etc) as well as the perennial problem of commutation and finality/certainty.”

Shaping the future

Whatever the wishes of investors and cedants, however, it seems there is still a long way to go. The primary side of the ILS sector remains embryonic compared with some asset classes and the secondary markets trail further behind.

“The ILS market is small—with maybe 50 public issues coming to market in a year and, as a result, secondary trading is thin. The price at which a security trades today is not necessarily the price at which you could place a hundred million dollars of risk,” says Davies.

Miller agrees: “When a capital markets cat bond is issued, often the headline coupon is comparable to a Rate on Line (RoL), so it seems to an insurance company or a risk hedger that the coupon equals Gross Rate on Line (GRoL), and that’s not true.

“Coupon typically equals ‘net’ RoL the investor would receive. That ‘net’ RoL has to be grossed up by the following three factors: brokerage; Federal Excise—assuming that it’s the US paying a premium to the outside; and the frictional bond building costs. That will give you the overall costs from a risk hedger’s perspective to compare what they would be paying for otherwise traditional coverage.”

Currently, a handful of institutions make up this market, providing bids and offers for a good number of ILS issues.

“We are starting to see the embryo of a working secondary market, and while the traditional reinsurance market has been reluctant to adopt electronic trading, it is likely that such a platform, combined with electronic documentation and a recognised clearinghouse system would work very well for secondary ILS trading—and probably for new issues as well.

“The development of similar markets such as those in asset securitisations and syndicated loans will provide a useful route map,” says Davies.

“True secondary markets lead to lower risk transfer prices, deep liquidity, transparency of pricing that influences the primary market and allows for complex trading and the ability to unwind risk and collateral positions efficiently. Any combination of these would change the reinsurance market profoundly and open up many opportunities for perceptive investors.”