The coming of age of non-catastrophe insurance-linked securities

For the past decade, casualty and specialty (non-cat) insurance-linked securities (ILS) have largely been in the shadows of the more established property catastrophe ILS market.

However, as non-cat ILS has matured, it has started to garner significant interest from investors.

These backers have typically invested in property catastrophe exposure but now, for many, the non-cat ILS space is their first investment in insurance liabilities.

The investors in these two products explore very different investment strategies. Those interested in catastrophe ILS have traditionally been looking for under­writing returns with no or low correlation with the financial market, with investment returns forming a less significant proportion of overall returns.

The higher volatility associated with catastrophe ILS has also meant a more conservative investment strategy has been employed, with the assets used as collateral being highly liquid to ensure obligations can be met should a catastrophic event occur. 

This has meant most of the collateral has been in the form of cash, government securities, money market funds, and short-term government debt. Catastrophe ILS investors have also generally been seeking shorter-tenor or shorter-duration investments.

In contrast, the investors that have emerged to take advantage of the non-cat ILS space are looking for lower volatility insurance business, longer-term investments, and have an appetite for longer-duration or longer-tenor risk. Although still an important consideration, underwriting returns form a less substantial part of the overall returns generated by non-cat ILS investments, with investment returns generated from a broader range of assets accounting for a larger, more significant proportion of the total returns generated.

Consistent cashflows

Well-structured non-cat ILS investments can generate consistent cashflows, with the float available to asset managers for further investment, substantial leverage where premiums generated are multiples of the initial collateral invested, and access to a broader pool of risks – potentially expediting the creation of larger, more diversified portfolios of insurance risk – which are attractive to larger investors.

Interestingly, catastrophe ILS funds have also started to explore non-cat ILS, often in partnership with established specialist non-cat ILS practitioners, as a way of diversifying their offerings to existing investors. 

This could potentially attract a new set of investors who may be resistant to participation in property catastrophe business.

This desire may also partially reflect the challenges many catastrophe ILS funds have encountered when attempting to grow beyond around $10bn of assets under management (AUM). 

There are various potential reasons for this, but perhaps the most pivotal is that only certain structures are appropriate for these funds as there is a requirement for them to be fully collateralised to limits with the only leverage being created by the premium. That in itself may potentially incentivise riskier, high rate-on-line (RoL) transactions.

Collateralisation to limits makes layers with reinstatements and those with low RoL generally less desirable. 

Consequently, there are only so many single-shot and aggregate layers – whether in the form of catastrophe bonds, parametric covers, industry loss warranties or retrocession – available at acceptable pricing.

Historically, many of these purchasers have also been concentrated in specific areas, with Florida immediately coming to mind. This potentially results in concentration risk, which is an additional inhibitor of growth. Various methods have been explored to alleviate some of these issues, such as the use of rated reinsurance fronts.

Still, these all come at additional cost and there are very few that would be willing to accept multi-billion-dollar portfolios, which are potentially in competition with their own business. These points have not been lost on many catastrophe ILS managers, with some now actively exploring the potential of non-cat ILS as an engine for continued growth.

The conclusion that should be drawn from this is that catastrophe ILS managers are recognising non-cat ILS for what it is, a potentially highly accretive addition to their catastrophe ILS offering and not something that is either a detractor or competitor, with both being well-structured and designed products that offer investors direct access to a wide variety of insurance risk.

Not only are investors and catastrophe ILS managers starting to recognise the opportunities in the non-cat ILS space, but cedants are also recognising the value that is being added. 

Many investors in the non-cat ILS space have AUM running to the hundreds of billions of dollars and are looking to build large portfolios consisting of significant individual positions on programmes.

Additional third-party capacity is highly attractive to cedants as it reduces reliance on traditional reinsurance capacity. This additional capacity has proven particularly attractive to MGAs, a segment of the insurance market experiencing rapid growth.

Many of these MGAs have concerns that their reinsurance providers may be actively competing with them or, if the product is particularly niche, they may be using these MGAs for education purposes, with a view to launching a competing offering in the future.

Concerns around the casualty ILS product have been voiced on numerous occasions and in various forums. 

However, it could and should be argued that these have often missed the mark, generally reflecting a lack of understanding of the product, something that perhaps points to practitioners in this space inadequately articulating the product or perhaps not being given an appropriate forum due to the dominance that property catastrophe ILS has had over the sector.

Misunderstanding

Critics have routinely pointed to the spectre of a zero-interest environment as a significant concern, but this indicates a fundamental misunderstanding of the non-cat ILS product.

First, duration matching of assets to liabilities ensures this is not a concern in the current high-interest rate environment – and nor will it be for the foreseeable future.

Second, the nature of the product means investors are not restricted to risk-free rate return products, with assets that can be used to collateralise non-cat ILS structures able to generate significant returns, even in a zero-interest rate environment, which are further enhanced by the leverage that can be created by appropriate structuring. It should also be noted that many investors are holding such assets in any case.

Third, non-cat ILS is potentially a longer-term investment – typically five to 10 years – with zero or negative interest rate periods generally lasting only a few years and only very rarely global in extent.

Finally, a zero-interest rate environment would likely result in a hardening market driven by the needs of rated insurance and reinsurance companies, which typically have highly conservative investment strategies.

Reserve strengthening

There have also been concerns raised over reserve strengthening in the US casualty market. This is not a universal phenomenon across the entire class and is a reflection of the individual company’s underwriting strategy and portfolio mix. With appropriate diversification, this risk can be mitigated.

The elephant in the room – social inflation – is often cited as a concern. It is indeed a legitimate one but goes to the very heart of the skill of portfolio managers and underwriters in appropriate risk selection, structuring and curation of diversified portfolios, and the application of effective claims handling and legal strategies, which mitigate the risk to investors.

In summary, non-cat ILS finally appears ready to enter the mainstream alongside catastrophe ILS.

At present, non-cat ILS represents only $3bn to $4bn of capacity, but there is a strong conviction in the ILS community this will grow to around $10bn by 2026.

This meteoric growth appears easily achievable but will depend on non-cat practitioners both educating investors and continuing to create innovative structures that allow investors to exit positions after defined durations – usually five to seven years.

This feature will substantially broaden investor appetite. Such solutions have started to emerge, but as non-cat ILS expands, additional products and increased competition will be required to facilitate this growth.

Kier James is chief underwriting officer at MultiStrat