The resurgence of ILS

17 February 2015

Written by Gavin Parker

Gavin Parker, head of intermediaries, funds and captives at Barclays in ILS Guernsey examines why Insurance linked securities (ILS) have become a popular asset class once again.

It is a symptom of difficult market conditions that sophisticated investors look around for new types of investment, needing to work harder to get a return on their assets.

In the current economic climate we are seeing investors being more savvy about the products, structures and services they are putting their money into and also being more realistic about the returns that are possible and available. One key way that investors are adapting is to seek alternative investment options and diversifying their exposure to different asset classes, which may offer better returns, whilst still having a focus on appropriate risk management.

Diversified portfolios can mean more alternative methods of wealth and asset management. In some cases new products are dreamt up by innovative financiers and in other cases we are seeing the revival of products that have been in the background during the boom times.

Insurance linked securities (ILS) is one such area. With the insurance industry continuing to write more diversified lines of business e.g. Cyber, Terrorism and hijack, the industry is continuing to seek more efficient ways of accessing capital. At the same time, investors are looking for better returns and diversification in asset classes which are un-correlated to financial markets; ILS offers a mutually beneficial opportunity.

In terms of return generation this method of asset management is making a comeback with significant amounts of business starting to take place, particularly in offshore jurisdictions like Guernsey. ILS are financial instruments with values driven by insurance loss events. ILS will often feature high severity, low probability events known as CAT bonds (Catastrophe bonds). For example these will include losses caused by natural disasters and uncontrollable events. CAT bonds in their own right are very risky so an insurer will seek to minimise this risk.

The general approach by the insurer will be to either charge a premium equal to the expected annual loss or to seek to re-insure the CAT bond and in doing so, transferring part of the risk to another insurer. Both of requirement of the structure which is to have equity (cash) in the structure to meet the requirements of the insurer who is fronting the insurance.

This equity will be raised from investors who participate in the structures. A Special Purpose Vehicle (SPV) is established which has two functions; to issue securities to the investors and to provide re-insurance for the insurer. The SPV will typically collect the investors’ cash and deposit this into a trust and in this action the investors become the settlors of the trust and the insurer becomes the beneficiary of the trust.

Throughout the lifecycle of the ILS, if there is a catastrophic event the SPV will meet the costs of this event and the requirements of the insurer. If there is no catastrophic event the investors receive back their collateral and any interest payments due to them under the structure. The ILS sector is just one example of a niche area that is becoming increasingly more important for Guernsey’s finance industry. Expertise in both the fund administration and insurance sectors has led to Guernsey quickly becoming a specialist.

There are several potential factors at play that make Guernsey an ideal jurisdiction for ILS. The island is well-regulated and well-recognised as a finance centre. Many elements of international finance are already represented in the island, meaning there is a strong collection of practitioners and firms with the skills required to provide ILS. In particular, Guernsey is strong in both funds and captive insurance.

With ILS sitting at the meeting point for investors seeking alternative asset classes and access to insurance linked returns, it makes the island the ideal home for ILS. Guernsey has additional strengths in the existing insurance license system and with a strong pool of non-executive directors (NEDs) who are already familiar with insurance products, private equity and other funds and who will strengthen the independence, experience and oversight of the board.

Guernsey has a fiduciary sector which is adept and capable of arranging and managing the SPVs and trust vehicles needed to successfully facilitate ILS arrangements. When coupled with a banking sector which has appetite and expertise in all of the relevant disciplines needed for ILS, Guernsey is well positioned for continued growth.

Further, with ILS a key growth area, more banks in the island are adapting quickly and looking at ways to support ILS. In some cases this will be a new client base and although barriers to entering this market are high the benefit of working with a new sector will bring a greater depth of support and with it innovation. In addition a major differentiator for Guernsey is the ability to offer two innovative cell structures; incorporated cell companies (ICCs) and protected cell companies (PCCs) with some ILS funds using both structures in their ILS growth strategies.

These structures provide a low cost, low administration vehicle to access returns from the re-insurance market. The island also benefits from good connections with London providing great access for fund administrators, lawyers, accountants and bankers with specialist knowledge of captives and insurance and an understanding of the island’s finance sector.

Traditionally, an ‘insurance client’ has meant a structure managed by a captive manager, often wholly owned by a large corporate or PLC. With ILS there is more diversity. Sophisticated investors and institutional investors are attracted to the new product. These investors are often more used to private equity as they are HNW or cash rich. This combination plays into Guernsey’s key strengths and whilst market conditions are right ILS will continue to have a growing presence in the island.

An original version of this article was published by Private Client Practitioner’s 2015 Guernsey Special Review, January 2015.

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