Is non-Cat ILS comparable to fixed income?
ILS is structured typically like a debt instrument. The general format has the coupon being paid on a quarterly in arrears basis - similar to other debt yielding instruments,” says Erik Manning, a Director at BMS Re, a broker focused on insurance and capital markets.
The National Association of Insurance Commissioners (NAIC), a US standard- setting organization, describes ILS as notionally being floating-rate notes as the coupon is paid partly based on a money market return. Typically, the coupon is reset every quarter, so changes in monetary policy tend to make little difference to the securities’ value.
The market is even exploring the possibility of some non-Cat ILS transactions being given a credit rating, a practice that is integral to the fixed income space. For instance, Vesttoo, a platform linking insurance exposures with capital markets, has been working with well-known global rating agencies to obtain ratings for their transactions. The idea is to confer some non-Cat ILS transactions with credit ratings to give them validation with institutional investors.
“It is going to give people that additional bit of confidence that the mathematics supporting the deals are robust,” says Manning.
He believes that credit ratings will play an important part in expanding non-Cat ILS beyond the world of dedicated ILS managers making the asset more appealing to fixed income investors. “This might ultimately benefit the market for ILS as a whole, introducing the potential for improved liquidity and depth of the market,” he says.
Bestowing credit ratings on ILS bonds started with the longer established catastrophe insurance linked securities (ILS) segment. These were used in early transactions in this space to make institutional investors more comfortable with these instruments.
Cat ILS caters for large high impact events such as earthquakes and hurricanes whilst non-Cat ILS revolves around life or property & casualty (P&C) insurance - namely lots of small claims, which individually have a low impact.
The Cat ILS market has since become dominated by specialist professional investors who don’t require credit ratings given their intimate knowledge of these instruments and the reinsurance industry.
Further down the road, there are ambitions among some players, such as Vesttoo, to create a secondary market for non-Cat ILS similar to what exists for some bond markets. That liquidity would likely widen the investor base and over time it could improve returns.
Another characteristic non-Cat ILS shares with parts of the fixed income world is the way these instruments are packaged. They are securitizations - a technique that some claim dates back to the 1860s in relation to farm, railroad and mortgage bonds. The technique is now well established with global structured finance issuance hitting around $1 trillion in 2022, according to S&P Global.
The legal structures supporting non-Cat ILS in terms of the special purpose vehicles and the instruments issued are all reminiscent of securitizations that make up much of the alternative fixed income bloc.
The Non-Cat securities tend to be distributed under Rule 144A of the US Securities and Exchange Commission private placement protocol, which limits participation to qualified investors.
But that’s where the similarities end. It is also where the special characteristics of non-Cat ILS can deliver real value to institutional investor portfolios: “Non-Cat ILS is not correlated to fixed income. It has a different risk profile,” says Thomas Rose, Head of Capital Markets, North America at Vesttoo. “Clients like the fact that non-Cat ILS has different risk-return characteristics to the main asset classes.”
Rose very much sides with the argument that non-Cat ILS is an asset class in its own right. He explains that unlike with fixed income, returns are not influenced by interest rate movements nor by events such as economic booms and busts.
For many asset-backed securities and corporate and emerging market bonds, economic downturns often presage credit downgrades and even defaults.
That’s not the case with non-Cat ILS. Instead, returns are predicated on whether claims exceed forecasts, though losses are capped so they can’t run beyond a certain level. For example, there could be an unexpected jump in auto insurance claims possibly due to a sudden rise in vandalism or increased driving leading to more accidents. However, such occurrences would be quickly reflected in higher insurance premiums once those policies came up for renewal.
But fundamentally, most P&C insurance products have long histories and are backed by large quantities of claims data to support risk models. The nearest comparison with fixed income would be estimating the number of defaults in the underlying loans packaged in a securitization.
However, non-Cat ILS is simply not impacted by the factors that drive performance of most fixed income securities. And therein lies the attraction.
Also, it is very attractive to institutional investors holding US dollar investment grade bonds who are seeking to improve their yields. They may already be getting a 4-5% yield from these bonds and can use non-Cat ILS to generate another 2-3% that is non-volatile and predictable. Those cash flows are paid from collecting the premiums on insurance policies. Tenors don’t usually stretch beyond four to five years, even for traditionally longer duration risks such as longevity and mortality in the Life sector.
Indeed, non-Cat ILS’ unique characteristics are starting to entice more investors to take a closer look. Late last year AM Best noted in a report that the investor base for non-Cat ILS could be expanding beyond family offices and specialist ILS funds.
Some of the more recent non-Cat ILS transactions have been sold to treasurers of large corporates, pension funds and asset managers with dedicated alternatives departments.
AM Best reckons the expansion of non-Cat ILS may come through structural innovation attracting more types of investors into the market. This includes offering a broader range of products that appeal to different investor needs. As the market develops it is likely to be seen as an asset class in its own right given its unique characteristics and diversifying properties.
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