Zurich-based Twelve Capital is only five years old, but it, along with similar companies, has already fundamentally altered the reinsurance industry. It’s taken a remarkably short period of time for “alternative capital” to morph into “insurance linked securities (ILS),” and to become established as an integral part of the reinsurance industry.
John Butler, a managing partner at Twelve Capital, explained in a telephone interview how the company, which was founded in 2010, has since taken its place in finding and expediting the formation and management of the funds and specialized vehicles that utilize ILS products, primarily as investments.
Butler explained that in the recent past it was still possible to create and run mono-line re/insurers; making it easier for financial managers to invest in a specific company, as they knew what they were investing in and what level of profitability they could reasonably expect.
The situation changed, however, “as rating agencies stepped in and regulations made it necessary to diversify,” he said. As a result finding a reasonable investment and achieving the desired return on that investment became more difficult. Investors, however, still “want continued access to the more profitable lines of business that yield the higher returns.”
Butler explained that the investors he is talking to are highly sophisticated. They have the “core knowledge” needed to make the most appropriate investment decisions. Pension funds, the main investors, employ experienced managers who “have typically already done a significant amount of research before they even explore entering the [ILS] market.
“They’re not looking for high risk products; their approach is a more conservative one, as they are seeking to diversify their risk,” he continued. “They generally target solid single-digit returns – five or six percent – from carefully selected investment opportunities.”
If a pension fund puts as much as one percent of its assets into the ILS market, that alone, given the huge amount of assets that they have, satisfies the need for diversity without the need to take any excessive risk.
Butler also explained that this conservative approach tends to direct those investors more to the developed markets of the U.S. and Europe, along with Japan, where interest in ILS is increasing, and Australia. “The developed markets are the core Cat Bond markets,” he said, “with some investments going into terrorism and marine risks as well.”
Given the knowledge that investment managers already possess, when seeking to enter the ILS market, they are well informed about the companies who manage the funds that make up that market. They have also formulated their own requirements. In other words they know what they’re looking for and where to find it.
As a result, “investment managers have a short list of people who meet those targets,” Butler said. “Those are the people they contact.” What follows carries the same designation as the studies required for mergers and acquisitions (M&A); i.e. “due diligence” and guidelines are set that form the “parameters of the investment.”
Once those have been decided upon the investor selects the most appropriate “vehicle to hold the invested funds.” In many cases this is an “established fund with other investors,” which matches the guidelines of the investor.
Other instances may require the establishment “of a stand-alone vehicle,” which Butler described as a “bespoke,” or tailor made, entity serving the requisite guidelines of that particular investor. In each case it’s “necessary to find the appropriate investment vehicle and to review all aspects of the transaction.”
The most commonly used entities are Catastrophe Bonds and collateralized reinsurance contracts. The latter, as Guy Carpenter explained “is one in which a market creates a trust account at the inception of the contract term and funds the account in an amount equal to the contract limit (less certain deductions).”
Reinsurance brokers frequently contact companies like Twelve Capital on behalf of their clients, when they are looking for alternatives to traditional reinsurance. “They come to us,” Butler said, and then it’s up to Twelve Capital to “decide what [type of] investment vehicle might be the most appropriate.”
Butler indicated that in some ways the ILS market acts in the same capacity that Lloyd’s syndicates used to, and that some still do. Each syndicate would often focus on handling one particular type of risk. This gave an investor the option of participating in a specialized risk formation, rather than become part of “a basket of larger investors.”
The ILS market is now part of the reinsurance market, and it looks set to continue as such. For one thing the stable nature of the investors – mainly pension funds – evinces their intention to remain in the market for the long term. They aren’t going to suddenly start pulling their money out of the reinsurance industry, even if investment returns decrease, or there’s a rise in interest rates.
Asked whether the reinsurance industry has problems in continuing to be relevant in today’s world, Butler said it is “as relevant as ever” and that it remains “systemically important,” as “-“-rated reinsurers-” are still the central providers of coverage. He explained that the ILS market is really “just a new way of doing business,” and has actually “made the reinsurance industry more relevant.” It fills the space that was part of the cycle; i.e. raising rates after large losses, or forming new reinsurance companies.
The one area that continues to elude the ILS market, as well as the reinsurance industry generally is casualty coverage. The long tail risks inherent in the policies make it very difficult to model, as there are so many variables. “What we need to do,” Butler said, “is to figure out how to invest in this area of the market, but not in a way that it’s subsidized by the Cat business.”
In conclusion Butler looked at where the ILS market might be going in the future. He pointed out that at present it’s generally limited to the “top tier of investment capital,” as well as being primarily focused on developed markets. Expanding ILS investment opportunities to the next tier of potential investors would offer a way to attract “untapped capital.”
Expanding the market geographically would also offer more opportunities; provided that “it is prudently done, one territory at a time,” and that the “right kind of investments” are the ones chosen for the expansion. That will require time being taken to learn more about any area that could become a site for “investment in the future.”
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