A sanctuary from low interest rates

“The ILS space will increasingly offer access to insurance risks outside natural catastrophe risks.”
Dominik Hagedorn, Tangency Capital

The value proposition for ILS is clearer than ever, and the long-term outlook for the asset class is bright, Tangency Capital’s Dominik Hagedorn tells Bermuda:Re+ILS.

These are challenging times for investors. The low interest rate environment has made it difficult to generate attractive returns in the bond markets. Equity markets have made for happier hunting grounds, but the disconnect with the real economy serves as a constant reminder that things can change very quickly.

Institutional investors have long been interested in opportunities to invest in new kinds of assets that offer diversification from these traditional markets, and many have already made allocations to insurance-linked securities (ILS). How confident these investors will be to increase their allocations, and to what extent other investors that have not yet taken the plunge will follow them, is perhaps the biggest question facing the industry.

“Over time, I expect the low interest rate environment to drive more money into alternative investments, including ILS,” says Dominik Hagedorn, partner at Hamilton-based alternative investment company Tangency Capital.

He adds a note of caution, however. “Investors are attracted to ILS because of the low correlation to other asset classes but insurance risk is not for everyone,” he says.

“In the short term we may see more money coming into ILS as a result of the attractive market conditions, but some investors are also cautious given the recent loss experience in some ILS market segments.”

Hagedorn points out that the risk-adjusted returns available in the current market are among the best that have been seen for years, which bodes well for existing investors.

“The upcoming renewal seasons will offer a lot of interesting investment opportunities,” says Hagedorn. “I am optimistic that we will see continued discipline by reinsurers and higher returns on ILS going into 2021.”

Who to attract?

The ILS sector has decisions to make about what it wants to be, and which investors it wants to attract. A large pension fund that has large equities and bonds exposures will have a very different perspective from that of a dedicated manager that invests exclusively in ILS.

“Some investors use ILS as a diversifying asset class for the highest return potential in it, while others want to see more diversification within the asset class itself, because there can be a high concentration of exposure to US hurricanes, for example,” says Hagedorn.

Those in the former group may be less interested in new types of ILS products that provide intra-asset class diversification than a pure ILS manager that has no diversification from its equities and bonds exposures. The future of the ILS industry will depend in part on which of these types of investors takes precedence.

Hagedorn believes the future will be in increased product diversification.

“The ILS space will increasingly offer access to insurance risks outside natural catastrophe risks,” he says. “Cat will of course continue to grow, but as the coverage needs from companies and individuals evolve, new opportunities emerge.

“Even in property catastrophe there remains a significant protection gap, which ILS can help to address.”

Technology will play a huge part in that evolution, and will drive improvements in the ILS industry in terms of things such as modelling and exposure management.

“There is an opportunity to use technology such as artificial intelligence to improve our understanding of risk and data analysis, to make it more granular and insightful,” says Hagedorn.

“There are a million and one ways that technology can help deliver that, and cut costs along the way. One thing that doesn’t change is that along the value chain, someone needs to provide capital to back the risk.”

Clearing the way for growth

Traditionally, the collateralised ILS market multiplies reserves at the end of the risk period by a contractually agreed factor to ensure that, if there is an adverse loss development, there are sufficient funds in the trust account to pay for incremental losses.

The result is that those funds can’t be put to work in the subsequent risk period—the phenomenon known as trapped capital. Whatever path ILS takes, it is clear the industry needs to address this structural issue.

Trapping capital for potential adverse development is very inefficient for investors, notes Hagedorn, especially after loss-intensive years when those funds can’t be put to work in the following hardening and attractive market environment.

“The ILS industry has learned a lot about trapped capital in the last three years,” says Hagedorn. “In the years leading up to 2017, we had a relatively benign period where some structures had not been stress-tested, but with the recent loss experience, we can now see what works and what doesn’t.”

Hagedorn says Tangency avoids most of the issues around trapped capital because it specialises in quota share transactions, where capital is rolled into the subsequent risk period without employing any buffers.

“Our counterparties value this setup, as it reduces capital volatility, and they therefore offer this structural setup as part of the transactions we invest in,” he says. “This approach has largely solved the trapped capital issue for us.”

Others that do not invest in quota share transactions need a different approach.

“For collateralised reinsurance investors, the rolling capital structures are more expensive to implement,” says Hagedorn. “Through a fronting provider, buffers can be negotiated down at a price, but that is expensive.

“Alternatively, managers can sell their trapped capital positions but they are required to pay a significant price for it, which dilutes returns.”

Some managers borrow from banks against the trapped capital, he notes, but he believes the cost of capital for most banks makes it hard to do this sustainably. “The cost of capital for hedge funds is even higher,” he adds.

Images: Palamarchuk

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November 2020

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