Jean Louis Monnier : « There is a very practical demonstration of the decorrelation of the ILS market »

Next-Finance: Swiss Re is one of the leaders on the “Insurance-Linked Securities (ILS)” market. How would you define this market and what activities does it encompass?

Jean Louis Monnier: This market regroups all the transfer activities of insurance risk towards capital markets. It consists in the transfer of risk under bond form (the cat bond market) but also included a more private transfer of risk concerning derivative products or collateralized reinsurance solutions that are also deposited to investors. The total volume of the ILS market amounts to nearly 30 million dollars with half being cat bonds.

ILS are often presented as diversification assets. However, several assets that were historically considered as uncorrelated to traditional markets have revealed the contrary during periods of crisis. What is the real situation regarding ILS?

If we look at the performance of this market, we realize that it has behaved quite well even during the crisis. There hasn’t been any year with negative performances even in 2008. Swiss Re has published a performance index which represents a benchmark of the catbond market, the most visible part of the ILS market. During the 2008- 2009 period, it has risen by 16.5% which is a rather good performance compared to other asset classes. Only the last quarter of 2008 has experienced a negative performance which was mainly due to the sale of positions in a market that was still very liquid and which compared to all the other asset classes has behaved quite well. Beyond this theoretical aspect which considers that a financial crisis cannot cause a natural catastrophe, there has been a practical demonstration of the diversification process and decorrelation from the ILS market which nowadays one of the decision factors for the new investors looking to position themselves on this segment.

There is a specific condition on this market which wants each bond to have an independent risk analysis which is provided to investors and produced by one of the 3 main agencies which are AIR, EQECAT and RMS. These agencies provide the market with a global certainty on its models allowing risk evaluation of natural catastrophes

Jean Louis Monnier

This market seemed to attract only hedge fund type of investors but it is progressively attracting the interest of pension funds, sovereign wealth funds and institutional investors. Do you see some strong interest for these products among this type of investors?

Yes absolutely. What we can see is that since this market is more mature, the historical performances increase credibility regarding investors as it was one of the only uncorrelated segments to equity markets during the crisis. We see a growing acceptance of this asset class among institutional investors and particularly pension funds. Even if this market remains theoretically uncorrelated, it can nonetheless display some volatility during periods when natural catastrophes occur. But pension funds have this long term vision that can allow them to compare the risks and the returns of this asset class on a proper time frame. They consider this class as being particularly attractive within the framework of portfolio diversification strategy. Pension funds intervene either directly or through specialized funds that have an expertise in this field and which manage diversified portfolios exposed to insurance Linked Products.

The Insurance Linked Securities have rather strong return on investment targets. We have most notably seen coupons with + 550 to + 900 basis points above the Euribor reference according to the tranche for the Cat Bond Pylon II of ERDF. The Atropos fund that was recently launched by SCOR Alternative Investments has a target of + 700 basis points above Libor. Do investors properly understand the associated risks on these products? The “triggers” on some Cat Bonds seem quite complex. Is there a clear vision of the conditions of non-payment of the notional?

It is a market that is based on a transfer of insurance risks. Investors have paid a certain premium above Euribor or Libor which corresponds to a risk premium on the principal linked to the occurrence of a catastrophe. Are the investors equipped to understand this risk? Yes, there is a specific condition on this market which wants each bond to have an independent risk analysis which is provided to investors and produced by one of the 3 main agencies which are AIR, EQECAT and RMS. These agencies provide the market with a global certainty on its models allowing risk evaluation of natural catastrophes. And it is those same agencies which, by using these same models will provide their independent vision on the risk on bonds issued. To this specific risk analysis, a structural analysis of the rating agencies will be added. It on the basis of this communicated information on risk that investors will carry out an analysis of risks and decide whether to invest or not.

The pension funds intervene either directly or through specialized funds who have an expertise in this field and which manage diversified portfolios exposed to Insurance Linked Products.

Jean Louis Monnier

Direct investment in Catbonds is a market that is meant for qualified institutional investors which manage a minimum of 100 million dollars and which have the ability to evaluate the risk on these transactions. It is not surprising to see that these dedicated funds that were mentioned above constitute more than 50% of the market. This is due to the fact that they allow institutional investors to benefit from the diversification properties of this asset class without them having the expertise. The investment will be carried out by managers that have the necessary experience to measure the risk on those investments.

The PERILS index, an independent entity, supported by a consortium of insurance companies reflects the intensity of the trend in Europe. Does it bring more clarity to investors? Can it act as a reference for the payment of coupons?

PERILS brings a view on the exposure for each market, by activity and by geographical location hence the exposure of the industry concerned. After an event, it will bring an estimation of a loss for the industry per activity and per region allowing a global view of the loss caused by the event. Nowadays, PERILS mainly provides its services for losses linked to European tempests.

For issuers, it is a tool that allows to have an index reference of the industry and depending on the market shares of an issuer can provide a relatively strong correlation between a weighted PERILS index and the real compensation losses of an insurer. It is an efficient risk transfer tool for the sponsor in the sense that he will diminish the basis risk (the potential gap between the losses of the insurer and recovery by the cat bond). For investors, it is a transparent index which will reduce the risks associated to a compensation portfolio. (a compensation portfolio will concentrate the subscription risks or payments for accidents that are relevant to an insurer whereas here we have a trigger that references a global loss and reduces the risks on a specific insurer). It is therefore a tool which is highly used by sponsors and investors alike to transfer tempest risks.

External observers tend to underestimate the liquidity of this market which remained nonetheless highly liquid even during difficult market conditions .

Jean Louis Monnier

One of the recurring complaints of investors on this type of product is the relatively opaque secondary markets and the spreads which happen to be quite large…Can we say that these products are exclusively “buy and hold” types without the possibility of an easy exit?

No, I believe that external observers tend to underestimate the liquidity of this market which remained nonetheless highly liquid even during difficult market conditions between the end of 2008 and early 2009. It was a period where the volumes of the secondary market have been historically high. There have been movements on the secondary market but the performance has remained positive on the whole of 2008. We have observed a significant liquidity level and a market that has very well performed compared to other asset classes. The major part of the volume on the secondary markets are carried out on rather narrow bid/offer spreads with market makers such as Swiss Re bringing market liquidity or acting as intermediaries between buyers and sellers. Where I shall agree with you is on the fact that many investors buy positions to construct a diversified portfolio and will manage their asset allocation in a relatively stable portfolio. In that sense, we can effectively talk about investors which have “buy and hold” strategies. They buy to cash in premiums knowing that an insurance risk is taken by conserving it but it is in the nature of the markets to be that way even more than trading activities. This positioning must not hide the fact that until now, liquidity has always been good and that the trading spreads are rather narrow considering the nature of risk.

The cost linked to catastrophes has been increasing after the Japanese earthquake and the resulting Tsunami. If these events have the ability to provide incentives to insurers and reinsurers to transfer more of their risks via markets, they however run the risk of the decreasing the motivations of investors. How do you see the future of the “Insurance Linked Securities” market?

The Japanese earthquake has led to losses on the catbond market if look at the impact on the Swiss Re index and it has caused a drop of 4% and if we look at the direct losses linked to the market and spread widening on some other asset classes. There is an impact but it’s no surprise considering the scale of the catastrophe with its epicentre being at the north east of Tokyo but not quite near Tokyo. The bonds that have been affected were those that were the most exposed to this region. For investors there hasn’t been any surprise in the ensuing losses. This has led to a certain confidence in the modelling of these risks and investors have increased their exposure to catbonds instead of panicking. They were maybe doing so in the hope of benefiting from higher spreads in the future. We have therefore seen an increased confidence from investors regarding this event.

An insurer who buys a protection can take into consideration the benefit of this protection within his internal capital model.

Jean Louis Monnier

And how do you see the future of this asset class which gives the impression of being very anglo saxon? Will it develop further in Europe?

Historically, it is a market that has developed around the market of American risk transfers. The hurricane risks are those that concentrate the biggest cost for insurers en reinsurers in the US. It is the risk for which the spreads are the biggest, return for investors is the highest and it is a risk which has the greatest concentration for the market and offers diversification for investors. It is the heart of the market. But what we’re seeing with PERILS (which brings diversification to European investors on events such as tempests, earthquakes or Japanese typhoons) is a strong narrowing of the spreads since 2008 which makes them more attractive for sponsors. The combination of narrower spreads with new tools such as PERILS constitute a favourable factor for market growth and the arrival of new sponsors in the coming years. We are rather optimist on the demand for sponsor protection but also the ability of markets to meet this demand for protection.

What will be the impact of solvability II on this market?

It must first be noted that the benefit that capital market access provides (allowing for a diversification of liquidity sources out of the market for reinsurance in collateralized form) is an aspect which is facilitated by Solvency II. In particular, benefit recognition from an AAA collateralization can be a favourable factor for futures issues.

There will be recognition of the quality of credit provided by the collateral and recognition of the risk transfer regardless of its form, not only in the form of reinsurance quota but also risk transfer in index form or under catbond form. This will be recognized in the internal models of the insurers. An insurer who buys a protection can take into account the benefit of this protection within its internal capital model.