In uncertain times, investors embrace ILS

    ILS – an asset class that comprises financial instruments such as catastrophe bonds (i.e. cat bonds) – allows institutional investors to capture a premium that is uncorrelated to traditional equity or fixed income price movements, while allocators only pay out losses as and when disaster strikes. Investor flows into the ILS space have also been stoked by the unprecedented low interest rates, which have suppressed returns over the last 10 years. As a result, Willis Towers Watson found the ILS market has undergone a significant expansion, and currently stands at USD93 billion (as of 2018), an increase from USD88 billion one year prior.1

    Source: Man Institute (October 2018) As the catastrophe bond market matures, some themes are emerging which may be appealing to ESG investors.2


    Andries Hoekema, Global Head, Insurance Sector at HSBC Global Asset Management, says long dated institutional investors such as pension funds, sovereign wealth funds (SWFs) along with some ultra-high net worth individuals have found the broadly uncorrelated alternative risk premia and risk diversification benefits offered by ILS enticing. “Interestingly, we are also seeing a growing number of insurance companies themselves invest into these bonds, which is unexpected as they are normally the ones writing the insurance,” he adds. The growing popularity of ILS among insurers, he says, is partly a result of the Solvency II rules, which enable insurers to add diversifying insurance exposure to their portfolios through ILS at low marginal regulatory capital charges.

    ILS and its unique ESG selling point

    With the growing regularity of weather-related natural disasters, a protection gap is now opening up as non-governmental organisations (NGOs) and public sector bodies find it increasingly difficult to pay for the costs of remedying catastrophes, a point made by Helen Goonewardene, Vice President, Relationship Manager for HSBC located in Bermuda. “A lot of the countries which are disproportionately impacted by catastrophe risk are developing markets where there has historically not been a strong tradition of insuring risk. By sponsoring these issues, it enables local NGOs and governments to obtain the necessary funding to provide aid when catastrophes happen,” adds Hoekema.

    The growing popularity of ILS among insurers is partly a result of the Solvency II rules, which enable insurers to add diversifying insurance exposure to their portfolios through ILS at low marginal regulatory capital charges, says Hoekoma.

    In response, Hoekema says more governments and NGOs are now actively sponsoring ILS issuances as they look to transfer some of the risks and costs that come with providing aid and support following a disaster onto the capital markets. For investors, ILS is an asset class which can help them meet their ESG (environmental, social, governance) requirements, especially as many institutions are coming under mounting pressure from their own clients and regulators to take sustainability issues more seriously. Catastrophe bond investing is now seen as a very compelling ESG proposition for investors, according to Goonewardene, insofar as it helps them cement their ESG credentials among end clients and regulators.

    Case study 1: Catastrophe Bonds and ESG in Turkey
    Turkey is a country where insurance adoption is quite low, yet it is simultaneously a region that is highly prone to serious earthquakes. For example, the Kocaeli and Duzce earthquakes in 1999 cost the Turkish economy USD20 billion, of which only USD1 billion was insured.3 In response, the Turkey Catastrophe Insurance Pool (TCIP) was established in conjunction with the World Bank, in order to provide residents with mandatory earthquake coverage. TCIP has also issued a catastrophe bond (Bosphorus Ltd Series 2015-1 Class A), a bond that automatically pays out to the TCIP under a set of pre-agreed triggers.4 If a major earthquake were to strike Istanbul today, Swiss Re estimates around 20 per cent to 25 per cent of the USD90 projected billon plus in damage costs would be covered because of this initiative.5

    Case study 2: Catastrophe Bonds and ESG in the Americas

    In October 2012, New York suffered in excess of USD30 billion worth of damage following Super Storm Sandy, of which USD5 billion was incurred by the Metropolitan Transportation Authority (MTA).6 To mitigate the threat of future storm damage, the MTA sold a USD125 million catastrophe bond through a Bermuda-based vehicle – MetroCat Re Ltd – that will transfer risk onto investors.7 It is hoped this issue will prevent the MTA from having to dig into its already constrained budget to pay for repairs should another storm strike.8

    Likewise, a number of cash-strapped Caribbean countries are also turning to catastrophe bonds to insulate themselves against hurricane damage, the economic impact of which has been truly devastating. For instance, hurricane costs on some islands have reached 200 per cent of gross domestic product (GDP).9 The Dominican Republic – in coalition with the World Bank – recently issued a USD150 million Catastrophe Deferred Drawdown Option although efforts are underway in the region to create a multi-country catastrophe bond.10

    In 2018, the World Bank unveiled one of the world’s largest ever catastrophe bonds to date, providing collective earthquake coverage totalling USD1.36 billion to Peru, Mexico, Colombia and Chile. According to the World Bank, the catastrophe bond issue received USD2.5 billion of investor orders.11 The World Bank also added that each country benefited from significant legal cost savings as the transaction was structured as a joint issuance.12

    While there has been a lot of emphasis on Blockchain[…] we are seeing a lot of product innovation in the trustee business, in terms of streamlining and improving reporting and messaging, as well as accessing and managing portfolios, says Goonewardene

    Technology and the ILS market: Ripe for change?

    The impact of disruptive technologies such as Blockchain (also known as distributed ledger technology) on capital markets has the potential to be quite transformative. In areas where intermediation is rife such as insurance/reinsurance, Blockchain could play a meaningful role in delivering efficiencies and cost savings. Blockchain exchanges have already been rolled out in Bermuda’s reinsurance market, streamlining placement, accounting, settlement and claims, and there are plans to introduce the technology into ILS transactions as well.13 If Blockchain is successful, Hoekema says it will help automate a number of manual processes that continue to permeate throughout the ILS transaction lifecycle, speeding up execution/turnaround times, and lowering the frictional costs of risk transfers.

    In response, providers such as HSBC are investing heavily into various Blockchain initiatives, conscious of the technology’s growing influence and role in financial services. “In 2018, HSBC was among one of the first banks to use Blockchain technology to issue a letter of credit using a platform developed by R3. Issuer Services has made investments into the technology too as we look to further explore opportunities for Blockchain solutions on the agency side of the business. While we have seen one ILS player – Solidum, a Switzerland entity with a Guernsey ICC [see case study below], utilise Blockchain solutions to ‘replace’ the traditional trustee component of the transaction, we are at least a few years away from this becoming a mainstream solution for clients," comments Goonewardene.

    Case study: Issuances using a Blockchain

    In 2019, Switzerland-based insurance/reinsurance linked investment firm Solidum Partners completed a USD12 million private catastrophe bond issuance using a Blockchain technology called ILSBlockchain.14 Since ILSBlockchain’s inception back in 2017, a total of USD50.1 million worth of catastrophe bonds have been issued using its distributed ledger.15


    While there has been a lot of emphasis on Blockchain, other innovations are also being trialled, says Goonewardene. “The trustee business is admittedly quite commoditised but we are seeing a lot of product innovation, in terms of streamlining and improving reporting and messaging, as well as accessing and managing portfolios. A number of banks have also spoken about creating a massive data warehouse to expedite the client KYC (know-your-customer) process,” she highlights.

    HSBC as a solution provider

    HSBC Issuer Services has a long and extensive track record, providing a best in class escrow solution working on complex transactions including ILS. Through its escrow capabilities, HSBC can assist clients with their risk management (mitigate timing risk, counterparty risk, etc.). With its sizeable global network, HSBC is able to support transactions across a diverse range of markets too. Most significantly, the bank’s robust balance sheet and strong credit rating make it an ideal counterparty from a risk and asset safekeeping perspective.

    To find out more about HSBC Issuer Services:


    References:

    1 Insurance Journal (February 1, 2019) Insurance linked securities market grows to USD93B in 2018: Willis Re

    2 Man Institute (October 2018) As the catastrophe bond market matures, some themes are emerging which may be appealing to ESG investors

    3 Man Institute (October 2018) As the catastrophe bond market matures, some themes are emerging which may be appealing to ESG investors

    4 Swiss Re (October 25, 2018) Risky cities: Earthquake resilience in Istanbul

    5 Swiss Re (October 25, 2018) Risky cities: Earthquake resilience in Istanbul

    6 Reuters (July 15, 2013) New York’s transit authority to sell USD125mln ‘catastrophe’ bond

    7 Reuters (July 15, 2013) New York’s transit authority to sell USD125mln ‘catastrophe’ bond

    8 Reuters (July 15, 2013) New York’s transit authority to sell USD125mln ‘catastrophe’ bond

    9 Artemis (November 30, 2017) Caribbean regional catastrophe bond back on the agenda

    10 Artemis (November 30, 2017) Caribbean regional catastrophe bond back on the agenda

    11 World Bank (February 7, 2018) World Bank affirms position as largest sovereign risk insurance provider with multi-country earthquake bond

    12 World Bank (February 7, 2018) World Bank affirms position as largest sovereign risk insurance provider with multi-country earthquake bond

    13 Insurance Journal (March 6, 2019) ChainThat to launch Blockchain-driven re/insurance risk exchange in Bermuda

    14 Artemis (March 26, 2019) Solidum issues USD12m private catastrophe bond using ILSBlockchain

    15 Artemis (March 26, 2019) Solidum issues USD12m private catastrophe bond using ILSBlockchain

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