Q&A with Towers Watson ILS consultants Matthew Ball and Todor Todorov
With the issuance of cat bonds and insurance-linked securities (ILS) instruments forecast to hit record levels in 2013, the emergence of ILS as a more mainstream asset class and the anticipation of continued growth in the level and scope of capital market participation in new areas of reinsurance risk transfer, we asked Matthew Ball and Todor Todorov from Towers Watson to provide us with some insights into the ILS market from their clients’ perspectives.
Matthew Ball is a Director at Towers Watson within the Risk Consulting and Software business and is based in the Bermuda office. He has extensive experience providing consulting and software solutions to both the traditional (re)insurance industry and the ILS market. Todor Todorov is an Investment Consultant at Towers Watson and is based in the New York office. He specializes in hedge fund research and has advised a number of pension fund clients on asset allocation to ILS.
What makes ILS an attractive investment for pension funds?
Todorov: Institutional investors look for good investment opportunities that will bring diversity to their portfolios. This makes ILS particularly interesting, as the risk associated with the insurance risk premium is fundamentally very different from the risks associated with traditional equity and credit markets. An economic slowdown, a credit crisis or a traditional asset class bubble burst does not cause natural catastrophes. We do recognize that there may be some relationship in the opposite direction (i.e., traditional financial markets being impacted by a large insurance loss event), but generally, the correlation of ILS with the rest of the financial markets is low. Development of ILS into a more mature market, together with investor education and better understanding of the underlying risks, has led to growing acceptance of ILS as an asset class in its own right.
What are some of the issues investors consider before allocating capital to ILS?
Todorov: We touched on some of the high-level advantages of ILS as an asset class above, but the amount and type of ILS allocated still depends on individual investor preferences. It is important that investors considering allocation to this space understand the nature of the market and the risk/return profile of the asset class. It can play a long-term strategic role in a well-diversified portfolio given its diversification benefits, but the left tail associated with this investment suggests that the allocation should be sized appropriately and closely monitored.
Ball: I’d like to expand on some of the operational aspects investors consider. Many investors do not have the same depth of experience with ILS versus the more familiar traditional financial market investments. Therefore, we are seeing increased demand from investors for more formal governance structures around the independent valuation of ILS portfolios — where not already required by regulation or the fiduciary duty of the asset manager — particularly for the more illiquid or hard-to-value securities outside cat bonds. The traditional asset management industry is no stranger to this demand from investors, given their fees are directly based on the net asset value (NAV) of the fund. The traditional reinsurers entering the third-party capital ILS fund space are starting to experience this same demand to formalize the governance. Investors are also looking for evidence of expertise and infrastructure on the underwriting side. In this area, you may expect the traditional reinsurers entering the ILS fund space to have a head start, at least initially, assuming they can leverage their existing capabilities.
The capital markets are still very much focused on peak cat perils. Do you think this is set to continue?
Ball: Although the capital markets are still mainly focused on peak cat risk, and we think there is still growth potential in this area, we believe the capital marketization of peak risk is just the tip of the iceberg. We expect, and are starting to see, more capital market activity in other parts of the reinsurance spectrum, such as life, accident and health, and embedded value. There is also an increased interest in the securitization of casualty catastrophes and casualty attritional risks as the tools to model this risk continue to evolve. As more capital market money becomes available for non-cat peak areas of reinsurance, these areas will undergo a similar transformation.
Todorov: Most of the allocations from institutional investors have indeed been to products with a bias to the peak cat perils. This is understandable given these perils provide the diversification benefits that investors look for and offer an attractive premium per unit of risk. However, this is not to say that going forward institutional investors will not consider adding other risk perils to their portfolios. As they get a better understanding of this market and become more comfortable with it, I would not be surprised to see demand for other risk perils as well. For example, one may argue that mortality risk should be interesting to certain institutional investors that carry a lot of longevity risk.
How are (re)insurers and funds responding to the increased investor demand for ILS?
Ball: Reinsurers are responding by establishing their own third-party asset managers. This reflects an acceptance on their part that the market has changed. They have come to the conclusion that the capital markets are here to stay, and they need to compete head-to-head on the layers where the capital markets are involved. To do so, reinsurers need to have their own sources of competitive third-party capital. The fact that so many of them have established or are establishing these platforms illustrates this dynamic.
Sophisticated analytics and views of modeled and non-modeled risk will continue to grow in importance as third-party asset managers compete for capital. Those managers that can create and maintain an edge in the analytics space — for example, inward portfolio optimization and NAV modeling — will create an edge in returns. This is true in both the traditional reinsurance and ILS markets. The reinsurers that are setting up their own third-party managers should have a fast start in the analytics area if they can leverage their existing reinsurance company infrastructure. However, any ILS asset manager that realizes the potential value of superior analytics and risk selection and successfully implements them will reap the rewards of an uplift in returns relative to peers and an increased ability to attract more third-party capital.
What is Towers Watson’s focus in the ILS market?
Todorov: On the investment side of our business, we work with large institutional clients, helping them with their investment portfolios. In this capacity, we help them determine what role an allocation to an ILS product can play in their portfolio, how to size it appropriately and how to select a suitable manager or product that will provide access to this risk premium.
Ball: Within our insurance consulting and software business, we combine strategic and analytical skills to solve practical business problems, applying the latest techniques and software solutions to help our clients measure and manage risk and capital, grow revenue and create a competitive advantage. With our long-established position as the insurance industry’s leading risk specialist, in partnership with our investment consulting business, Towers Watson offers clients market-leading solutions within the ILS market.
Visit www.towerswatson.com/ils for more information.