ILS in Europe: New hubs, new structures, new risks

In attendance

1. Luca Albertini, chief executive officer, Leadenhall Capital Partners
2. Richard Godfrey, head of traded ILS at Securis Investment Partners
3. Malcolm Newman, chair of the London Market Group’s ILS Taskforce, EMEA Hub managing director, SCOR
4. David Pedlow, director of client services, JLT Advisory
5. Des Potter, managing director and head of GC Securities, EMEA, Guy Carpenter
6. Darren Redhead, chief executive officer, Kinesis Capital Management
7. Dominic Wheatley, chief executive, Guernsey Finance
Moderator: Wyn Jenkins, managing editor, Intelligent Insurer

Note: This roundtable took place before the UK government released details of new regulations designed to allow the UK to capture a share of the ILS market. The regulations, which the UK government said will “introduce a competitive regulatory and tax regime for ILS”, were due to come into force shortly after the summer recess.

They set out how to establish special vehicles to issue ILS, the legal framework for ILS, and the associated tax treatment. The regulations also provide for a tailored and proportionate approach to authorisation and supervision.

What is your vision for London’s becoming an ILS hub?

Malcolm Newman: It has been very much a collaborative process with the Treasury. They have allowed us to work alongside them in the development of the rules and regulations, and legislation to underpin the new activity. It has taken us probably two years to get to this point—we had draft legislation due to come out around Easter, which was unfortunately the time the election was called.

The last steps of the legislation have been revolving around some detailed review re legal and tax, and input to the regulations to make sure they were fit for purpose. In terms of the legislative side, the insurance-linked securities (ILS) Taskforce was very pleased with the outcome.

We hope it will be possible to form ILS vehicles this year. If we get towards the end of the year, the question is whether people will want to take the risk of forming an ILS vehicle before the legislation is passed.

Des Potter: The legislation was never put in place to compete with Bermuda, it was in response to the London Matters report that highlighted the value of the insurance sector to the UK economy, and the fact that reinsurance business, and the London Market’s share of reinsurance business, has continued to reduce. Part of the reason is that a lot of reinsurance—certainly in the property cat world—is being placed with the alternative investment markets. And those transactions are being executed in other jurisdictions.

Bermuda’s growth has been at the expense of business that may have started in London, but this new legislation isn’t there to compete with Bermuda, because Bermuda does a very good job, and is strategically well positioned bearing in mind so much of this market is US cat risk.

London is unique in terms of being a centre for re/insurance risk. We have more than 30,000 professionals in London across underwriting, broking, actuarial, legal—all the services related to risk transfer—so it’s just not about reinventing a property cat risk transfer market in London, it’s about using the capabilities of London and its ability to underwrite, structure and transfer risk from where it’s currently held to potentially more efficient places, ie, the capital markets.

The World Economic Forum in a report in July 2015 defined the alternative investment market as complex, illiquid, high risk investments, that have a longer duration than traditional asset classes.

Within this segment there’s $7 trillion of assets under management. The bulk of that goes to hedge funds, to private equity, and to real estate. But within that $7 trillion we’ve got $75 to $80 billion that’s going to ILS. Less than 1 percent of the allocations into the alternative investment market has actually come into our sector.

Why are pension funds and wealth managers allocated to this space? It’s because of the diversification benefit of the asset class, the low correlation with traditional assets classes. You’re in an environment whereby most of the developed world is earning negative real yields. Investors are looking for some form of relative value, for diversification, and increasingly, they’re allocating more to ILS strategies.

Luca Albertini: Back to ILS legislation—first, the assumption is a good government would want to give the market the ability to transact smoothly and easily in its jurisdiction. If a London based investor transacts via a Bermuda-based entity, someone could say, “you did it wrongly, you actually controlled the Bermuda cell” then investors could be subject to tax risk.

We have an established way of making sure things are done properly, but removing that uncertainty from an investor perspective would be another great benefit. When you look at the threat to other jurisdictions, what the Taskforce has tried to say is they’re asking the regulator to make sure that whoever manages these special purpose vehicles (SPVs) is actually competent. Areas where there is excellence such as Bermuda and Guernsey would definitely be beneficiaries of this legislation and part of the growing market that comes to London, as they could be involved in the administration process of UK-based entities.

Would a UK regulator be business-friendly and actively encourage the development of this market?

Newman: One of the big discussions we’ve had with the Treasury is how business-friendly is the UK regulator. It’s a common complaint, it’s not linked to ILS. It’s seen as one of the things that’s holding back the development of activity in the UK. The Treasury is very keen to promote further economic activity within our space and they are ultimately the ones to determine the objectives for the regulator.

Sam Woods, deputy governor at the Bank of England for prudential regulation and chief executive officer of the Prudential Regulation Authority says, “You will have a dedicated team to work on ILS,” which means you will get some expertise there. But also you need to have some objectives set for the regulator where they have an interest in developing the market, and that was taken away from them in 2008. They need to think of some way to reintroduce those types of objectives to the regulator so they will start to work more with industry.

Dominic Wheatley: From Guernsey’s perspective, business is going well. There are fundamental cultural differences between a large jurisdiction such as London, and a small jurisdiction such as Guernsey or Bermuda.

The culture is very much a small jurisdiction working together, people know each other. But we have a dedicated team, with consistent individuals. It is difficult with the type of arrangements we’re talking about here, to proceduralise and institutionalise the regulation of those. It requires consistency of individuals, in the regulatory environment and also in the administration.

That’s something which London may find more difficult, because there are more tempting alternatives for people working in the regulator here, and indeed in industry here, than is the case in Guernsey and Bermuda, where we specialise in bespoke complex financial administration. We have experienced and qualified people doing administration tasks—generally speaking London would move those people into different types of activities.

Bermuda and Guernsey are successful because of that internal connectivity, and because of the consistency of the individuals and the ability to accumulate expertise among the people who work in what is a very small niche sector. Probably across Bermuda and Guernsey you’re talking about tens of people, not hundreds.

From London’s point of view as a complete reinsurance centre they would want to have an offering, but the economic benefits of that are not strongly apparent to me.

It is ironic that London could have a talent problem. I know Luca works with a guy who has been working in this space for 10 years, maybe more. Would he have stayed in that specific niche space had he been that successful in London? Almost certainly not. And then somebody else would’ve had to come in and you would have lost the access and consistency. The environment in Guernsey is very much the environment that respects this sort of niche skills.

Potter: You have to think about where this market and reinsurance are going. The current model of reinsurance and to a degree insurance is no longer sustainable. The capital markets have thrown up the opportunity of forcing this market to think about more efficient ways to transfer risk. If we thought the ILS market was going to be the ‘crumb on the side of the biscuit’ analogy, we’re wasting our time.

We believe this market is going to evolve over the next three to six years. And the way risk is going to be transferred is fundamentally going to change. The days of post-event scenarios when a reinsurance company rushes to the equity markets to recapitalise itself are gone. After a major event re/insurance companies aren’t going to the equity capital markets. They’re going to go to the ILS markets and restructure their balance sheets between capital they need as core capital for their, what you might call attritional, business and capital that needs to be flexible to respond to the peaks and troughs of the cycle.

That’s where the opportunity lies. It’s not about continuing to do the small number of cat bonds and sidecars. If that was solely the opportunity, we’ve wasted 18 months. If London wants to maintain its very strong position globally to transfer these risks between risk providers and capital markets it needs to have a full toolkit. At the moment it’s working with an incomplete toolkit, and that’s a waste.

Darren Redhead: At the moment London is missing out. Most of the deals are going through London in one shape or form—even US cat business touches London—but then the risk is transferred to other jurisdictions. It isn’t just going to be reinsurance—people are going to collateralise other forms of risk. The insurer’s role is going to change over the next decade: does it just take tower risk? Some companies are sitting there saying ‘well, we’ll just halve our capital base and take tail risk and use alternative markets’, and should that be done in the London environment?

Kinesis is a Bermudian company. I can see the time when we transfer it to the UK, but that’s more the future. When I started in the industry 30 years ago, it was the centre, but it’s lost market share. I didn’t realise you were asking for regulation, for me that’s the biggest thing that will give investors comfort. In other jurisdictions they do a great job, but there’s not enough auditing regulation of the risk monitoring the asset manager. That will be a great evolution and give investors bigger comfort if there is some form of regulation.

Wheatley: That’s an investor perception issue. The idea that there is less regulatory oversight, certainly in Guernsey, is quite incorrect. It’s investor perception, but not reality.

Redhead: What goes in to the fund is audited, what goes out is audited. While it’s actually in the fund, it’s very much left to the investor and investment manager to oversee it.

What is the broader potential for the development of ILS in London and Europe?

Newman: We have to look at the wider infrastructure in London. There’s all sorts of ways that ILS could develop—people talk, for example, about secondary trading. As a very traditional reinsurer, we take on risk and hold it, and that ties up our capital forever. What are your options if you need more capital, you’ve got an opportunity but where do you go?

If we need to partner more with ILS funds on the right deals, where are we going to think about doing that? We’re going to do that in an established centre, but we don’t have an operation in Bermuda. There’s a lot of resistance in some territories on the continent to offshore centres, but London is not an offshore centre. If you want to then bring along secondary trading, London has a whole environment already in existence. There are many assets already using secondary trading in London, why not insurance assets? Those things could be put together here, because we have the critical mass of skills.

Potter: If London can use its capabilities in the financial markets to develop a secondary trading environment, it brings liquidity to a market that is totally illiquid. That’s part of the prize if we get this right and we get the right people thinking through how to do this.

We shouldn’t lose sight of how small a piece ILS is in the re/insurance world, with a small number of people active in that market. If you expanded the capabilities to the rest of the market, and say, look this is what’s possible. We’ve probably got 150 people in London doing ILS, but there are hundreds in Lloyd’s who have shown interest in ILS who can bring new ideas, innovation, and creativity.

Wheatley: You’ve mentioned a couple of key things. One is liquidity, and the key with liquidity is to attract more investors. It’s a relatively sophisticated asset class and one a lot of investment managers are shying away from. The other thing is that if you look at the innovation in Bermuda in the last few years and in Guernsey at the moment, it is very focused around the secondary market and that liquidity issue. We see that as very much part of the next stage of development for our industries.

Albertini: For the investor base, the biggest issue is the confidentiality clauses attached to traditional insurance. Coming from the banking market you wouldn’t have a chat with a client in a restaurant because you think the waiters will tell your competitor.

At Monte Carlo, all the competitors are speaking 20 centimetres from each other, yet in reinsurance treaties there is a confidentiality clause which de facto says: ‘don’t tell anyone about my risk, apart from the 500 people who already know’. Once you resolve that confidentiality issue (which I know is not easy) you have a massive move towards liquidity.

If you could allow some secondary market within Lloyd’s for example, with Lloyd’s clearly in front acting as an exchange clearing fund, you have transformed this business for good into liquidity.

Potter: The biggest challenge we’ve had in the Taskforce is to nudge the regulator forward, and make them think more commercially. But the reality here is that we have another regulator—Lloyd’s—that is expert in this market, has an understanding of the asset class and its complexity.

They’re not here to speak for themselves, so I’ll be careful what I say, but I think it was a missed opportunity for Lloyd’s not to be more proactive on this opportunity when it first started. They were far too defensive; if they’d been more open-minded in their potential role, you could’ve seen Lloyd’s take a different role in helping the PRA to oversee the development of this market, and the new legislation and supervision that’s coming. I hope they are going to catch up.

Redhead: It was a defensive mechanism. They are now playing catch-up—they could have had another $10, $20 billion voted on the side from ILS vehicles, and the farce of it all, is that nearly every single syndicate in Lloyd’s is using this market for outlook protection.

Does anyone agree that Bermuda has ‘stolen London’s lunch’ in relation to ILS, as Inga Beale said?

Newman: It’s a question of who that message is for. If you’re giving a message to your market base, to your underwriters to get out there and be a bit more innovative, then that message made some sense—‘you guys have slept on the floor and you could have had this’.

In the wider context it might look as though somebody’s stolen something from London, but in fact Bermuda, Guernsey and others have done a great job of innovating and developing this market. We’re going to derive a lot of benefit from the work done by those jurisdictions. It is disappointing that things weren’t innovated more in London and that’s what London Matters was trying to identify, why ILS is on the agenda. How do we bring back that innovation and that ability to do things here, and what stops us?

We need to keep focusing and banging on at the regulator and the government to be a bit more supportive—as they are in other jurisdictions. And then the innovation can flow.

Wheatley: Picking up on the Lloyd’s angle, I suspect they might be struggling with the fact they just don’t have an existing vehicle to fit ILS structures within. In Guernsey we are not worried about it—the Channel Islands has been described as ‘London offshore’ and we are an alternative environment within the London sphere. I’m quite comfortable with the idea that we innovate and develop ideas that then get translated into a bigger environment in London.

Potter: Many places around the world will take comfort from London regulation. Asian investors are more comforted with deploying their capital so far away from home in the London Market rather than a smaller jurisdiction that they—rightly or wrongly—have perceptions about. It’s an opportunity not only for risk transfer but also for attracting capital.

Wheatley: It’s not just to do with regulation. In our experience working in Asia and in the Middle East it is actually the expertise of London and the London industry as much as the regulation.

Potter: But I’m very aware that there is Asian money deployed in London now because they take comfort from the double regulation of the PRA and Lloyd’s, although there are clearly other factors relating to the business as well.

Is anything holding this market back? Are the investors willing? How might Brexit affect this vision?

Richard Godfrey: Continental Europe is not our major source of investor capital; our funds are domiciled in offshore locations and, with a couple of one-off exceptions, we don’t use any jurisdictions for transformer vehicles other than Guernsey and Bermuda. Essentially our business has built to the point it is now with limited interaction with the Continent.

We have viewed a potential angle of the London project to be the opening up of access, and the question is, has the Brexit vote made this objective harder to achieve? It is undoubtedly more difficult attracting European investors and cedants, particularly from countries such as France and Germany, when you have no vehicles within Europe, so the London project certainly can have big applications in that regard, and can increase our ability to market our product.

Will what is happening in London open the doors to more European-based investors to get into ILS? It may or may not, but it is certainly another tool, which should be of assistance.

Newman: We started this project before Brexit and we were quite optimistic that we had an untapped market in Europe that would see London as a very acceptable place to be transacting this business. The key in Brexit will be on what terms can the UK remain an open economy with regard to trading with Europe.

Albertini: The European investor base in Leadenhall’s funds is currently 80 or 90 percent pension funds backed. Pension funds are more a UK, Finnish, and probably Dutch phenomenon, in the sense that you have a vast accumulation of private pension money for decades. The kind of investor who has really warmed up to our asset class in Europe is rare outside those jurisdictions, and we do not see a major impact from Brexit in dealing with them.

When I was structuring with ILS my client base was European, and none of my clients would transact with an SPV located in offshore jurisdictions. After Brexit maybe we’ll start reducing our corporation tax drastically, and then EU-based clients may say, ‘London is an offshore tax centre’. We may need to wait at least a couple of decades in my view for the market not to associate London with a solid European framework and we are likely never to come to that.

Redhead: That’s going to be evolution of the industry. It isn’t going to be the funds all being frontline. They’re going to sit behind traditional rated carriers. The money will come into the ILS sector, but the ILS sector won’t necessarily be frontline. It will choose to reinsure its parent company, sell via other entities and get the leverage, and this all becomes blurred and that’s why the Taskforce would be great. It won’t be just black and white.

Wheatley: I don’t see that London is going to be in a fundamentally different position after Brexit negotiations as an investor destination from Europe. There are two aspects to this, one is how do you deliver the product, and the other is how do you facilitate flow of investment. The two will have different solutions, one of which might be through fronting or whatever, and the other of which will be through some sort of investment arrangements like AIFMD, although I suspect that neither Europe nor the UK would want to have that particular arrangement for London.

What about the origination side? Will we see more risks in Europe transferred in this way?

David Pedlow: Yes. Innovation is the topic, so having that extra tool through the ILS market will support and drive innovation. For London to continue with its relevance and to continue growing it is essential that it has that centre to leverage ILS. In the European market on the broking side cat rates are so low they’re close to break-even in some cases, even potentially under water.

A bit more of an uptick is that there’s interest to access the ILS markets, through private placements if a situation arises that we need to dive into that capacity for any reason, they have that experience and exposure.

All the top 25 P&C carriers have access to the ILS market in some shape or form, be that sidecars, cat bonds, or collateralised reinsurance, and effectively the private placement market has opened a new segment to allow those smaller to medium-sized companies access to both with restriction on costs and timescales.

Potter: Cedants are becoming more comfortable with collateralised capacity. The issue is where is collateralised capacity more efficient in a reinsurance programme. It started supporting top layer risk in property cat, but it’s now being used in a lot of different parts of the programme. We’re seeing collaterised capacity being used a lot in quota share programmes. And it’s coming further down the stacking to some of the working layers.

Collateralised capacity isn’t going to be efficient where you have an oversupply in the traditional reinsurance market. It’s very difficult for the collateralised guys to generate any form of decent economics in the current pricing environment in Europe, but as the rating environment changes, there are lots of ways where collateralised capacity can be used efficiently.

Cedants are more comfortable with using not only their collateralised capacity supporting reinsurers, but also directly from the funds themselves, so they’re getting more familiar with the trust structures and the form of risk transfer. The market continues to evolve and innovate, and we are beginning to see leverage creep in behind the collaterised capacity as well, enabling that capacity to find a role in different parts of the programme from what might have been seen before, eg in reinstatements.

Pedlow: European reinsurers have been very protective of their turf—is that sustainable in the long term?

Godfrey: I see little point in ILS investors effectively being just another subscription market infilling 5 percent of a particular layer here or there in a market that’s already overserved by traditional capacity. The longer term view and targets should be to be an integral provider of risk capital to insurers and reinsurers.

Redhead: One of the structural problems is that as an industry we try and compound growth, the profits, when we should be paying them back. I blame the investors for not taking the money back from us. You can’t regulate that, but it’s one thing the investors should be aware of. They should be taking the money off the table and just leaving us what they invested in.

Newman: Then your credit rating would get hit because when they ask, ‘where’s your capital growth plan?’ you say, ‘well I have a dividend policy which distributes 4 or 5 percent’, so part of your growth plan is retention of earnings. The better your earnings look, the better your credit rating.

Wheatley: It is part of the solution to your timing problem, the availability of a secondary market.

Redhead: I think the secondary market is a bit of an urban myth. It’s very difficult to trade zero or one, all the other secondary markets have different things that affect their pricing: interest rates, currency, the economic environment. To all intents and purposes we’ve got zero or one, it either happens or it doesn’t. That’s difficult to create a secondary market on.

Pricing doesn’t fluctuate much. Look at our secondary market, the prices vary greatly whether it be currencies or stocks. When do they fluctuate? They go down during a hurricane.

Potter: Malcolm made an interesting point about the psychology of a traditional insurer and reinsurer, because they’re a write and hold business. Having the ability to generate some liquidity on a percentage of the book has to be a good thing for risk management.

I acknowledge your point Darren in terms of what are the factors that will determine a movement in price. If you look at the traditional financial markets, you have different information coming in that will move price, but it’s really based on someone’s view of what they find an attractive asset at a moment in time.

People’s views change based on where you sit in the game. If you’re sitting with a long position on Florida and someone else has a different view on it, why can’t you create the opportunity in September to trade that position? We don’t have that—apart from a very blunt industry loss warranty instrument that is not very efficient.

Redhead: The big point is that London’s got to do it because it’s where the money’s coming into the industry now. The last time startups happened, post 9/11, post KRW, that won’t happen in the future, you might get one or two but 80, 90 percent of the money will come in via this sector.

And London, if it doesn’t get ready, will miss the next big thing. That’s what London should be aiming for, not getting on deals now—it should be aiming to get the infrastructure in place for when something happens.

Potter: Look at the sidecar market: it started out as a hard market opportunity where you quickly deployed capital to write in high yield conditions, and then once those conditions fell away, you closed the vehicle down and redistributed the profits. Now it’s a strategic vehicle to align capital with reinsurers that may not be so efficient in today’s market, but it’s scalable for tomorrow’s market.

Many of the reinsurers setting up sidecars know they need to build a relationship with the capital markets, because when market conditions change and there is a capital impairment event as there will be, they want to have a vehicle they can use to respond to those opportunities, to use that third party capital.

Put that alongside their existing underwriting capability, their broker and cedant relationships, and they can respond far more quickly.

Redhead: Is the regulator going to be the PRA or Lloyd’s? What do you think they would do post event?

Albertini: One thing that can go wrong is if the SPVs we build have an obligation that cannot be honoured, a valid binding obligation. That is driving the concern at the moment so they are very worried about the structural features we put around it, apart from 100 percent collateral from day one, every single year.

Newman: That’s the disadvantage of coming in late, if you’re a jurisdiction you would start off with 100 percent collateralised, maybe how Guernsey went. And you’ve got to match that from day one, that’s quite a big ask from a regulator, to set aside its former concerns.

Redhead: Post event, it won’t be just the regulator, it will be, ‘are the funds performing as they told their investors they were going to?’. And that’s what will dictate where the money comes in. The investors will gravitate to the ones that perform as they promised.

What are your final thoughts?

Newman: This is a unique situation in my career where the industry, government, and the regulator are sitting around the table trying to do something constructive to improve London’s position. It’s something that we need to build on.

Redhead: Investors will decide where the money goes. It’s going to be their choice.

Albertini: The capital is coming, and we’re looking for new opportunities. The idea is not to waste this capital. The insurance gap should be a clear focus for everyone. We are equipped, we have the money, we have the transactional tools. Now the governments of cat-exposed areas have to decide whether they foot the cat bill, or start spreading the risk.

Godfrey: We’re pretty well served with things as they are but the future question, in particular, is what happens post an event. The development of London as a domicile is certainly going to be an attraction to the purchasers of risk transfer from the ILS market, whether they do it in a reinsurance form or some other form of capital provision.

In terms of the opportunity as it stands within Europe before an event, I don’t see there is much at all for the ILS sector, the returns simply aren’t there, and they’re not going to be coming any time soon, until we have some form of capital event in the form of insurance losses or some broader financial crisis.

Wheatley: We developed the protected cell company structure that forms the basis of a lot of ILS structures 20 years ago. The development of London’s offering in this area is a natural progression as the market develops, and as the quantum of the market increases to a scale where the size of a London becomes an advantage. We see very much a continuation of that partnership, based as a quality administrator and as an innovating centre.

Potter: I believe the reinsurance market is going to evolve into a leaner, more capital-efficient and transparent market. I am proud to be on the Taskforce initiative to try and improve capabilities and the infrastructure of the London Market, but London’s got to decide whether it’s going to adapt, and whether it wants to be in the front seat or the back seat. It should be in the front seat, and I hope it continues to fulfil that role in the global market.

Pedlow: London needs to continue to embrace and use this new potential ILS framework, and to throw its support behind it to help bring to market these new potential risks that can deliver significant new growth and keep Lloyd’s relevant.