ILS structures are more complicated to understand but yields can run as high as 15%. They vary from private and collateralised reinsurance transactions to sidecars that are purpose built vehicles through which reinsurers relinquish premiums associated with a book of business to investors who place sufficient funds in the vehicle to cover claims if they arise. They are seen as tactical instruments of limited duration during a difficult market.
Other popular ILS investments include reinsurance swaps and industry loss warranties (ILWs), a variation of a reinsurance or derivative insurance contract whereby, for example, an insurer will buy coverage based on the total loss arising from an event.
CAT BOND-LITE
By contrast, cat bonds are tradeable securities with around three-year time horizons. They came onto the scene in the 1990s to help insurance companies mitigate the risk of disasters such as hurricanes and earthquakes mainly in the US but their popularity spiked after Hurricane Katrina in 2005 which caused $135bn in damages. Returns soared to double-digit figures and stayed aloft in the aftermath of the 2011 weather events.
However, despite the attention they still only account for roughly $25bn or a third of the total ILS landscape and issuance has been particularly sluggish this year with the first nine months of 2016 sliding 15% to $3.7bn over the same period of 2015, according to a report by the Property Claims Services unit of Verisk Insurance Solutions. This was mainly attributed to a slower-than-expected second quarter followed by a predictably light three months ending 30 September.
The report shows average year-to-date transactions were flat at around $230m, following a 19.5% drop from the first nine months of 2014 to the first nine months of 2015. One bright spot was the so called ‘cat bond-lite’ sector which comprises smaller transactions that require less robust documentation and disclosure than traditional cat bonds issued under the more onerous requirements of US Securities Act Rule 144A. The report notes that the streamlined process albeit rigorous and disciplined, has given the cat bond-lite platform “an edge over private catastrophe bonds”.
“They are similar to cat bonds but they are less expensive for issuers and have become popular,” says Marc Brogli, an ILS co-portfolio manager at Lombard Odier Investment Management (LOIM). “One of the unfortunate consequences though is that it has taken some of the issuance away from the traditional cat bond market.”
THE ATTRACTIONS OF CAT BONDS
Fallen yields have also hurt the market but numbers may be misleading. Many market participants believe Katrina and 2011 events distorted the figures and that they have now reverted back to their historic norms. “Returns in dollar terms are around 4% to 6%,” says Sandro Kriesch, head of private ILS at specialist insurance investment manager Twelve Capital. “In this current low interest rate environment, this is still attractive compared to other fixed income instruments.”
Diversification and low correlation are also main attractions. “They are not tied to, for example, financial markets but instead to natural catastrophes,” Axa IM’s Divet says. “If there is an earthquake in Japan it will have a small impact on equities but the effect will be short term. The other benefit is that cat bonds are floating rate notes with short maturities so they are not sensitive to interest rates and although spreads may be down, they are still higher than for corporate bonds with the same type of maturity and rating.”
