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Insurance-linked securities (ILS) are financial instruments issued by insurers and reinsurers to manage their exposure to low-frequency but high-severity losses. The ILS industry is continuing to evolve. This niche market has grown considerably since its origins back in 1997 as a response to the large losses insurers suffered by natural catastrophes (notably Hurricane Andrew in 1992) and is proving to be an increasingly attractive alternative asset class for sophisticated institutional investors, particularly pension funds.
Although some investors were arguably more cautious following the 2008 financial crisis, they seem to be getting more comfortable with the associated risk/reward profile that ILS products can offer. In fact, some commentators expect that the amount of capital seeking direct access to insurance and reinsurance risks from third-party investors and institutions will more than double to $150bn by 2020. The total global ILS sector is worth approximately $64bn and as at the end of 2014 Bermuda represented 57% of that global market.
ILS products (often seen in the form of catastrophe bonds – cat bonds), industry loss warranties and sidecars (which are financial structures established to allow investors to take on the risk and benefit from the return of specific books of insurance or reinsurance business) cover natural catastrophes such as hurricanes and earthquakes, life insurance (including mortality and longevity) and man-made events such as fire and terrorism.
ILS returns are thus ‘event linked’ rather than correlated with risks associated with the wider financial markets as you would find in traditional investment classes. Value is linked to the occurrence or non-occurrence of specific nonfinancial risks (e.g. Florida hurricanes). If there is no trigger event (no natural disaster) before the maturity of the security, investors receive their principal investment in addition to any interest earned on the investment during the lifetime of the contract.
The ILS market has been very attractive for both insurers and investors.
Insurers can offload risk and raise capital while life insurers can release the value in their policies by packaging them up and issuing them as asset-backed notes. The growing popularity of ILS as an asset class for investors largely stems from the prospect of returns not correlated with equity markets and the fact that investment in ILS provides diversification in an investment portfolio.
ILS fund structures are proving to be particularly attractive to pension funds because they offer the ability to improve a portfolio’s investment performance through uncorrelated investments.
As pension funds and other new institutional investors become more familiar with the ILS market and associated risks they have been increasingly allocating a larger percentage of their investment mandates into this area. In addition to diversification in a fund’s investment strategy, other benefits include: comparatively short investment periods (for example cat bonds are typically twelve months to five years); favourable risk-reward ratios (given the potential returns for investors through investment income on the investment in the ILS structure, against low probability trigger events); and (usually) low credit risk of the (re) insurer counterparties.
BERMUDA’S ILS OFFERING
Any fund managers thinking about investing in or establishing their own dedicated ILS fund structures should consider Bermuda, a jurisdiction widely acclaimed as the centre of catastrophe reinsurance expertise.
What has made Bermuda so successful in creating, listing and servicing ILS structures? In part this is explained by the excellent regulatory environment, overseen by the Bermuda Monetary Authority (BMA).
The BMA, Bermuda’s integrated financial services regulator, is responsible for the island’s risk-based regulatory framework which it frequently reviews to ensure it provides a robust regulatory regime that is also user-friendly and commercial.
Bermuda’s anti-money laundering/anti-terrorist financing legislation and tax information exchange agreements have further cemented its status as a premier offshore financial centre which is recognised by OECD on its white list of co-operative and compliant jurisdictions.
This regulatory framework offers institutional investors a very high level of comfort. Bermuda has further bolstered its position as market leader in the ILS sector by creating bespoke products to be utilised in ILS structures.
In particular, it introduced a legislative framework specifically for special purpose insurers (SPIs) (being newly formed collateralised reinsurance vehicles) which allows the creation of cost-efficient and more lightly-regulated corporate vehicles to be utilised in ILS structures. Applications submitted to the BMA on a Monday are processed by the Friday of the same week.
Another innovative legal structure which Bermuda offers (and which is utilised in ILS fund structures) is the segregated accounts company, which allows accounts to enjoy a statutory division of liability, effectively ring-fencing each segregated account from the general liabilities of the company and from each segregated account.
Coupled with recently modernised fund legislation which enables funds to register and launch faster (in some cases same-day), more efficiently and more cost effectively, the legal framework in Bermuda allows for greater flexibility in structuring transactions as well as making it faster and easier to bring ILS structures to market.
BERMUDA’S FUND SUPPORT SYSTEM
Speed to market is one of Bermuda’s biggest strengths and the BSX (the world’s largest offshore fully electronic securities market) responded to the needs of issuers of ILS (and their investors) by creating a streamlined and efficient process to list ILS. The BSX is very responsive and listing applications are typically turned around in seven days.
Growth and innovation in the ILS space in Bermuda is driven by the experienced and knowledgeable service providers based on the island. Being the location of one of the world’s largest reinsurance markets, the island has spent three decades building expertise in both the insurance and investment fund industry. Specialist ILS service providers range from administrative services to legal, accounting and other financial services. Bermuda is home to some of the largest dedicated ILS investment managers, including CATCo Investment Management and Nephila Capital.
The ILS market was very strong in 2014, with the BMA reporting 36 ILS issuances in that year alone with nine cat bond issuances totaling $2.2bn. The total outstanding volume of ILS cat bonds also rose 20% year on year. Based upon the first-quarter reports (which saw $2.062bn of new risk capital issued during Q1 2015 surpassing the previous busiest first-quarter in 2014, by almost $500m) 2015 will be another excellent year for the ILS market.
If investor appetite for ILS continues, there will be more opportunities for investors and we anticipate further diversification of ILS products. Industry commentators such as Clear Path Analysis report that diversification in the ILS market will be seen both in terms of classes of risk and their geographical location. It is anticipated there will be a shift away from predominantly US-based risks into new regions (for example, natural catastrophe risks in China, where they regularly experience earthquakes and typhoons). Additional diversification may also stem from new risks (for example, European flood) and models are being developed to quantify such risks. These additional perils and classes of risk will further aid diversification for ILS funds and investors and help ILS capital to broaden its reach.
With its reputation as a market leader in the space, Bermuda will continue to innovate and lead the market in structuring and servicing ILS products.
Originally published in HFM Bermuda 2015, June 2015.