Redefining Access: How Low-Volatility Non-Cat Risks Drive Diversifying Investor Returns
The discussion was led by Thomas Rose, Head of Capital Markets US, Vesttoo, and he was joined by a panel made up of Julia Henderson, Chief Commercial Officer, Vesttoo; Rob Palter, Senior Partner, McKinsey; Stefano Sola, Managing Director, Rewire Holdings; and James Lee, Managing Director, Aspen Capital Markets. All participants have direct experience of the asset class, and have seen ILS develop and adapt over the past twenty years into a key diversifier for institutional investors seeking returns uncorrelated to broader financial markets.
Readers are invited to follow the link below to watch the discussion, and this blog post contains a brief synopsis of the key themes that emerged.
The ILS market is at an inflection point today
First and foremost, all participants agreed that the asset class is right now positioned for dramatic growth over 2023 and the years ahead. The need for capacity in the primary insurance markets is simply too great to be met exclusively by traditional reinsurance solutions, and ILS with its ability to bring capacity directly from the capital markets is going to be essential moving forwards.
Within this overall growth of the asset class, the non-cat segment is likely to be a major contributor to this. A significant factor behind this is that, as emphasized by Julia Henderson, non-cat insurance lines represent non-binary event risk, in contrast to cat bonds where there either is or isn’t a natural disaster. This means non-cat ILS can offer more precise and predictable yield enhancement, without excessive risk.
A further attractive feature becoming available today for the first time is the ability to exploit not only the low correlation of ILS to traditional markets, but in fact the ability of different insurance lines to display no or low correlation to each other. It is now possible to construct portfolios to meet a very wide range of diversification or risk appetites.
Rob Palter points out that this is highly appealing today when the expected lack of correlation between some alternatives and public markets has weakened or in fact broken down today, with predictable negative consequences for the ability of some alternative-focused managers to achieve outperformance relative to public equity benchmarks.
He continued that this has gone hand-in-hand with a shift on the part of institutional investors increasingly focusing on macroeconomic risks and how they play across strategies, rather than simply on asset allocation decisions considered in isolation. For example, interest rate risk, commodity risk, and inflation risk are driving decisions about strategies at least as much as more schematic decisions over what blend of assets to include in a portfolio.
All panelists agreed that ILS can offer something to investors rethinking their allocations and macro risk exposures along these lines today. This shift of emphasis is already well underway and is expected to accelerate in the years ahead.
On this theme, Stefano Sola reminded the audience that part of the initial success of cat bonds was down to the fact that they were liquid, transparently priced and relatively easy to understand. This helped drive early investor demand which then meant the market was sufficiently deep to enable the development of subsequent more sophisticated instruments including derivatives, private placements, and quota share deals. The market is now ready for the next stage of its development, whereby the non-cat segment of the asset class can expand and drive the growth.
Stefano Sola summed the trends favouring ILS today as follows. Firstly, the need for primary insurance is only increasing, and there is either no capacity available or it is too expensive given the limited supply. Secondly, on the capital markets side of the equation, investors want alternatives and diversification. Crucially, these can’t be niche or overly esoteric, and the asset classes considered must be capable of absorbing significant amounts of capital. Lastly, dedicated ILS specialists are well aware that cat bonds have struggled for a number of years now and the volatility inherent to this ILS segment has held it back from attracting mainstream acceptance. Non-cat ILS is now ideally placed to meet all of these needs simultaneously.
Expanding access is key – multiple ingredients are necessary for this and they are all falling into place now
Julia Henderson reminded that investor education is still key to normalizing a new investment opportunity. Investors will only become comfortable when ILS providers can supply clear answers, and in a format they are familiar with, on the fundamental questions newcomers to any asset class will always have: Can we price the risk? Can we offer investors a return, and easy access to get their money out afterwards? Cat bonds have been struggling on these later points, especially around the issue of trapped capital, but several panellists agreed that non-cat has answers to these problems. With non-volatile insurance lines, the capital release mechanisms available today are much more sophisticated and allow for timely and predictable collateral release during the term of the instrument. This means risk-adjusted returns can be competitive without exposing investors to unpredictable and binary major event risk.
James Lee emphasized the importance of both modelling and subsequently explaining how risks have been modelled in winning over initially sceptical investors. He continued that rates of return on securitised P&C lines have been robust in the past, although market cycles are key and the ability of managers to adjust portfolios given the hardening/softening market dynamics. Julia Henderson developed the point further by linking the hardening/softening dynamic observed to the general lack of capacity in the market, and underlined that this is part of what provides third-party capital with such an interesting opportunity at the moment.
Rob Palter reframed the issue around the importance of clear and clearly explained risk modeling. He reminded the audience that risk modeling is and has always been inherently opaque for many alternatives, infrastructure and real estate being prime examples of this. Accordingly, the risk modeling practiced by ILS providers can actually be considered relatively advanced and transparent, and is unlikely to represent a fundamental obstacle to wider ILS adoption.
Thomas Rose likewise concurred that what really matters to investors is that they are comfortable with a given risk, and non-cat ILS in particular is making great progress on that front today. Rob Palter drew this discussion to a conclusion by role of portfolio construction and benchmarking, without which it is very difficult for investors to situate any new investment opportunity against something they are already familiar with. For example, an investor with a significant allocation to fixed income would want to be able to see a non-cat ILS portfolio compared against an appropriate fixed income benchmark. Fully drawing out these comparisons would also assist institutional investors in terms of conceptualizing exactly who within their team would be best equipped to handle ILS assets.
New instruments for an expanding investor base
The third major theme to emerge from the conversation was that there is still plenty of scope for the sector to evolve new instruments, and that this evolution of exposure mechanisms will likely go hand-in-hand with the expansion of the investor base already underway. Indices for the non-cat market segment, exchange-trade products and rated notes are all either currently available or expected in the near future.
Leading insurance investments ratings agency AM Best recently published a study that claimed the growing appetite for non-cat ILS has raised the prospect for an index play and/or ETF type structures. Julia Henderson agreed that an index play could work very well for non-volatile insurance lines, but again cautioned that it will take time to build the investor knowledge and confidence before this will be viable. However, although not currently available, all discussants agreed this will be a fundamental game changer in terms of making the asset class both easy to understand and easy to access.
Stefano Sola commented that communicating these developments to investment consultants will be key. Investment consultants advising institutional clients on new investment opportunities have a key place in the investment ecosystem given their primacy in terms of introducing and explaining new assets and strategies to investors.
James Lee reported that assessing and adjusting the argument to fit each investor's tolerance for complexity and liquidity is needed. Essentially, illiquidity is a feature of non-cat ILS right now and will continue to be so for the foreseeable future. The good news is that this means some level of illiquidity premium available, and Julia Henderson took the opportunity to highlight that fact that there is a reason Vesttoo has been able to place nearly $5bn in capacity – there is an appetite for this asset class out there in the broad universe of institutional investors.
She ended this fruitful and productive panel discussion by returning to the willingness and ability of ILS innovators like Vesttoo to meet the investor on their terms, and to provide attractive opportunities in the forms they want, be it rated notes, separately-managed accounts, and eventually via commingled funds and index-linked products.
To enjoy the full conversation, please follow this link to the recording of the session.