Does ILS Have a Transparency “Problem”?
The call for greater transparency in the structuring and trading of insurance linked securities has been gaining momentum since the 2008 collapse of Lehman Brothers and the resulting implosion of some catastrophe bond collateral programs.
At that time, several of the cat bonds for which Lehman acted as the counterparty were called into question. A review uncovered that some of the collateral had been invested in securities that became impaired, and the bonds lost significant value or defaulted.
For structures that were sold on their lack of “correlation” to credit, having cat bonds default for a non-insurable event had many investors questioning whether the risks were disclosed fully.
The transparency issue returned yesterday when a start-up looking to create an online trading platform for insurance derivatives and catastrophe bonds cited the industry’s lack of transparency for its inability to gain market traction.
“MyriasLive is now offline,” said a statement on the firm’s Twitter page. “Thanks for your support, unfortunately the market is not yet ready for full transparency and automated trading.”
Whether it is collateral management for new issues, accurate pricing in the secondary market or modeling consistency, participants generally agree more needs to be done to remove the opaqueness around the market.
But how quickly greater transparency can be achieved and where it is most needed is becoming a sticking point.
Secondary Market Pricing
For Myrias, its concept of an open and online trading platform for the ILS secondary market was a difficult sell in the current environment, says Simon Jenkins, founder and CEO in an interview prior to the firm’s closing.
“Things are very non-transparent and counterparties are very reluctant to put prices out, so most transactions are conducted by voice,” Jenkins says. “A large percentage of the market is traded by a handful of people and those institutions benefit from that system.”
Jenkins, who says he has implemented similar systems in other markets including foreign exchange, explains that reinsurance brokers often profit from sourcing and controlling ILS deal flow, and they are unwilling to share price information.
Additionally, he says reinsurance brokers have an incentive to keep ILS prices close to the vest to make sure their traditional reinsurance business remains profitable.
“If a buyer is paying a reinsurer 10 units for protection and the capital markets can cover the same risk for 8, all of sudden they’re squeezing their bottom line,” Jenkins explains. “ILS could take those deals away from them.”
But others argue that brokers have made significant strides on price discovery and transparency by hiring “market makers” to follow prices and manage market growth. And even though prices are not available electronically for many cat bonds, some argue that just having them available is an important step for the market.
Currently, John Seo of Westport Conn.-based Fermat Capital counts over 20 market makers in catastrophe bonds that are attempting to provide prices on existing deals in the secondary market.
The market makers are often set up by traditional reinsurance brokers to show clients that they have capital market “expertise” but trade very few bond deals, Seo says.
“The market is large enough that just being in touch with prices is an important attribute,” he explains.
New Investors, New Technology and New Information
Multiple forces are increasing the focus on transparency, says Fermat’s Seo.
“Transparency is a general movement in finance, but in the cat bond market it tends to grow whenever there is new technology introduced or if the industry is set up for rapid growth,” he says.
On the technology front, Seo argues that the adoption by market participants of the IntraLinks system over the past twelve months has greatly enhanced disclosure in primary issuance.
IntraLinks is a computer-based system launched in 1997 that allows traders in the syndicated loan market to exchange confidential documents.
Last year, IntraLinks began a voluntary program that would allow catastrophe bond issuers and brokers to submit documents into “virtual data rooms” to share information with investors.
“The IntraLinks mechanism is a huge leap because investors legally had access to documents, but it wasn’t timely or consistent in practice,” he explains. “As time goes on, the timeliness and detail of that disclosure will increase.”
Gary Martucci, an analyst with Standard & Poor’s in New York, agrees that the adoption of IntraLinks has been positive for the catastrophe bond industry but investors need to be proactive about understanding the documents they have been provided.
“It’s a wonderful tool. The problem is that you now have to read the documents.”
Seo agrees, adding that having too much information can be as destructive as too little.
“In the institutional market, when you are provided with information that you are not using or don’t understand, it can create a really bad dynamic,” he explains.
Jenkins says that although strides have been made in ILS transparency, it’s not enough for many institutional investors and that regulation may be the only way to open the market up.
“Regulators need to put pressure on the industry,” he says. “You only need to walk into the Lloyd’s building in London to realize it’s going to be slow going from the reinsurers.”
But calls for transparency are often simply a way to gain a business advantage for firms looking to enter the fast growing market, says Seo. “These new entrants that are not sitting on the desks of Goldman Sachs or Swiss Re Capital Markets really want access to go out and get advisory engagements,” says Seo.
These “next generation ILS managers” see the issue of transparency as a way to convince investors that current practices – in both reinsurance and catastrophe bond markets – are not up to standards of other markets.
Seo says he is skeptical of these arguments, adding that current cat bond participants act quickly when more information is requested by investors. “They keep trying to represent investors as being dissatisfied, and that’s not true,” he explains. “If you have a coherent statement in what you want in transparency, it tends to show up in the next deal.”
Risk Market News Newsletter
Join the newsletter to receive the latest updates in your inbox.