New ‘whole portfolio’ ILS asset class could be six times bigger than cat bonds

Vario Global Capital, the new venture unveiled by Guy Carpenter and Vario Partners last week, will help create a new asset class of insurance-linked securities (ILS) that will revolutionise the way insurers manage their capital and which could grow to be six times bigger than the now established asset class of catastrophe-linked bonds.

Nick Frankland, chief executive of Guy Carpenter’s EMEA operations and director of Vario Global Capital, told Monte Carlo Today that the venture represents a natural evolution for the reinsurance industry—but that this product could become very important over time as insurers increasingly use it as part of their capital structures.

Vario Global Capital will offer non-life insurers the opportunity to buy high level protection effectively on a quote share basis covering their whole portfolio using structures very similar to the catastrophe-based ILS deals that are now well understood by investors and cedants alike.

But the key function of such deals—which will, almost always, be by private placements into the capital markets—will not be risk transfer as such, but capital relief for insurers under Solvency II or equivalent regulatory regimes in other countries. This will deliver greater capital efficiency and improved returns on equity.

“This is a natural evolution for the risk transfer industry and it has the potential to be very important and very big,” Frankland said. “If it is as viable and successful as we believe it will be, our estimates suggest that based on take-up levels similar to what we have seen in the cat bond space, this market could grow to become five or six times bigger than that market but with much larger limits and premiums involved as well.”

Based on the way the needs of cedants have changed in recent years, he believes the appetite is there for this product.

“We have been increasingly acting as an adviser in recent years as clients want to discuss capital optimisation in the same context as risk transfer, and they want to understand the options available to them,” Frankland said.

“We think the industry would have ultimately arrived at this point anyway but Solvency II has certainly represented a pivotal point in changing the way insurers manage their risks and seek capital relief.

“This new venture will offer some revolutionary solutions on that front. We believe the investment markets will arrive at a similar point and be receptive to these risks. But we do not see this as a product that would cannibalise traditional reinsurance, since its primary purpose is not risk mitigation.

“Instead, in the same way that cat bonds have ended up complementing traditional reinsurance in the catastrophe risk space, largely providing capacity on peak risks, these bonds will complement the other forms of capital management available to insurers, including traditional quota share arrangements, sidecars, different forms of debt and equity.

This is not about risk transfer, it is a very different structure from that.”

Trigger solutions

One of the biggest inhibitors that has prevented non-catastrophe risks being transferred into the capital markets historically has been the difficulty of establishing a suitable mechanism for a bond being triggered and funds being released. This has always been particularly tricky in relation to long-tail liabilities.

James McPherson, a founding partner of Vario Partners and a director of Vario Global Capital, explained that his company has developed solutions to this problem using actuarial methodology.

The specialist insurance analysis and modelling firm has developing innovative portfolio modelling technology capable of setting triggers based on the performance of an insurer’s whole portfolio, taking into account factors including validated internal capital models and loss ratios.

“These deals effectively represent quota share deals, which insurers and regulators will be comfortable with, but transferred into a bond that can be sold to capital markets investors,” McPherson said.

“The bondholder gets a straightforward fully collateralised bond not linked to a credit even or specific catastrophic event but the overall level of claims across an entire portfolio. It will include some cat risks but everything else as well.

“The bonds will be triggered only by very adverse claims experience—with probabilities of one-in-100 or one-in-200. These bonds will not replace reinsurance; they will operate more at a capital level and reduce the way equity operates within these companies, thus offering significant capital relief.”

McPherson admits that an education process will need to take place with investors, as it did when cat bonds were first developing as an asset class. But he added that many investors will be unperturbed by the concept since they already invest in similar risks in a different way.

“You can’t replicate the types of triggers used on cat bonds but many investors are very familiar with whole portfolio insurance risks because they might be investing in equity or debt from this sector already,” he said.

“What is more, they will also be used to triggers based on non-credit events because of other forms of securitisations they invest in. We think investors will get comfortable with these deals quickly.”

McPherson added that, unlike traditional risk transfer structures, this product is aimed more at the CEOs and CFOs of insurers. “They will be planning the equity, debt and mix of risk transfer options available to them and this new product could complement those options,” he said.

“This could be of huge corporate value to a CFO. We also believe that it could grow as a product because of the competitive disparity that will emerge between those who use it and those that do not. In the same way that no firm can realistically operate in the cat space now with no ILS strategy, the same could ultimately be true at a corporate level in relation to this product.”

The founding partners of Vario Global Capital expect the concept to develop and evolve.

While the initial purpose of the venture is to structure and place private placement bonds on the basis explained, Frankland said the project could evolve to the point that it launches and manages funds in its own right.

If this were to happen, Guy Carpenter would take more of a backseat, he said. “Under those circumstances, we would dilute our involvement into a minority position. “We would like to remain involved and perhaps we would become a preferred partner of the fund but it would no longer be appropriate to be a lead partner in those circumstances.”