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Cat bond market benefiting from a “flight to simplicity” in ILS

13 November 2020

The flight to quality in the insurance-linked securities (ILS) market has been well-documented, as some investors have opted to shift allegiance to ILS fund managers that are deemed higher quality, due to their longevity, track-records, or affiliations.

But now we can add to that a “flight to simplicity”, coined by RenaissanceRe CEO Kevin O’Donnell recently, specifically referring to the catastrophe bond market.

Together, quality and simplicity cover a lot of the bases that institutional investors are seeking within the ILS asset class at this time.

Institutional quality, quality of the portfolio of risks invested in, quality of track-record, quality of process, strategy, documentation, reporting, terms and conditions, people and partnerships, amongst other factors.

Simplicity goes hand-in-hand with some of these, particularly around the terms, conditions, precision of coverage and understanding of the potential for losses.

Nobody would ever say that catastrophe bond documentation is simple.

But the extensive nature of it, with well-defined terms and named perils often the focus, does make the predictability of what may happen during the term of a cat bond, in terms of losses or otherwise, or extensions and trapping of collateral, much simpler to understand and anticipate.

Compared to collateralized reinsurance portfolios, where terms can differ much more significantly from deal to deal, while coverage can be much broader, and trapping of collateral a little less predictable as a result.

Simplicity might also be termed certainty, as that it what investors are looking for at this time.

Not certainty that they won’t face a loss.

Institutional investors such as pension funds are extremely realistic when it comes to the ILS asset class and their potential to face losses.

Having performed their due-diligence and understood what it means to invest directly into assets that are exposed to insurance and reinsurance risk events, investors in ILS expect they can lose a lot of their allocation in a particularly bad year, some of it in a number of years and occasionally have relatively loss free years.

But greater certainty that the loss will be via an event that was expected, more predictable, less surprising and certainly not completely unexpected or unanticipated, is welcomed by many of them.

The catastrophe bond market offers a lot of these certainties and a good deal of simplicity, compared to more complex portfolios of reinsurance and retrocession underwritten in numerous forms of coverage, with numerous types of documentation.

Which is, of course, the natural way of the ILS market, that both these products are available and often are co-mingled together in ILS funds, that allocate a portion of their assets to the less simple, sometimes less certain collateralized reinsurance, with a portion also allocated to the perhaps more simple and certain catastrophe bonds.

On the heels of three years of major catastrophe losses and facing a fourth year of trapped collateral due to the COVID-19 pandemic, there is little surprise we’re seeing these flights, to both quality and simplicity.

RenaissanceRe’s CEO Kevin O’Donnell highlighted this for the catastrophe bond market, saying that his firms cat bond focused Medici fund had one of its best performances in its history in the third-quarter and looking forward, “we expect it to continue to benefit from the flight to simplicity the cat bond market is currently experiencing.”

Over the years, through the rise of collateralized reinsurance, repeatedly major pension funds and sovereign wealth investors have expressed a desire for more cat bond issuance, as the fully-securitized nature of an asset with features of secondary transferability, aligns much more closely with the kinds of assets they are used to investing in.

Cat bonds, in many institutions eyes, sit alongside other forms of debt and credit securities, in terms of how investable they are.

Where as collateralized reinsurance is often seen as more of a hedge fund type strategy, where a manager constructs investable portfolios from assets that aren’t immediately designed to be consumed in such a way.

Of course, at their heart, the two are much the same.

An insurance or reinsurance agreement, collateralized fully in some way and transformed into a security that can be invested in or consumed into an investment fund.

But the note like output of a full Rule 144a catastrophe bond issuance is still seen as the simpler investment option, which is why some larger pensions and multi-strategy investors allocate to the cat bond market directly, but don’t do the same with collateralized reinsurance.

Cat bonds also hold an element of simplicity for investors as they are a fully-underwritten asset, where analysis and modelling is done upfront by third-party service providers and the deals underwritten by experts, before the notes are issued, marketed and sold.

Cat bonds are also more broadly marketed, by broker-dealer groups, making them more accessible to more types of investors.

Collateralized reinsurance, on the other hand, requires access to risk and underwriting expertise in order to gain the contracts to be transformed, securitized, and invested in.

Cat bonds seem more readily investable and more easily so, to the majority of investors.

None of which is to say catastrophe bonds aren’t complex, hard to understand, don’t require underwriting knowledge of the risks and an ability to model them. They are also full of nuances, sometimes opaque and lacking in details of the underlying exposures.

But, at a time when the insurance-linked securities (ILS) market has faced losses and trapped collateral to the degree seen in the last few years, the catastrophe bond is coming out as a simpler, cleaner, perhaps more broadly accepted option, in some investor circles.

Alongside the flight to quality, this flight to simplicity will benefit the catastrophe bond market greatly and we could see a significant step up in size of the outstanding cat bond market (as a proportion of overall ILS assets) over the coming decade, we believe.

Already, 2020 has beaten its first annual record for the catastrophe bond market and right now seems set to beat pretty much all of the others.

Add to this the evident expansion in the range of cat bond sponsors that we’re seeing, such as the news of Google parent Alphabet seeking to become a cat bond beneficiary yesterday, as well as the entry of other new sponsors this year, and the future looks bright for catastrophe bonds.

You can view information on every catastrophe bond issued so far in 2020 and all prior years in the Artemis Deal Directory.

Keep up-to-date with the make-up of the catastrophe bond and ILS market using the Artemis Catastrophe Bond & ILS Market Dashboard, designed to be a simple and effective tool providing key data and statistics on every transaction (there are 700+) contained in our catastrophe bond & ILS Deal Directory.

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