While a solution to Greece’s sovereign debt travails has dominated financial media, specialist insurance investment manager Twelve Capital believes this is largely a non-relevant solvency issue for European insurers and their investors. Twelve Capital managing partner and head of sourcing John Butler explains

John Butler

For our investible universe, given post financial crisis asset de-risking, direct balance sheet exposure to Greece is now immaterial. Good reporting transparency shows that reduced exposure in sector peripheral Europe is largely focused on Italy and Spain – better placed peripheral sovereigns that we expect to continue benefiting from strong ECB support if required. We draw comfort from strengthened European bank balance sheets given that Financials remain a major investment asset class for European insurers.

We see Solvency II as the key fundamental issue that will impact insurance debt and equity investor sentiment over the remainder of 2015. By contrast, market volatility associated with recent macro events naturally positions the Insurance-Linked Securities (ILS) asset class at a sweet spot in the fixed income space, due to its low levels of correlation to broader financial markets and strong risk-adjusted yield opportunities.

Positively for debt investors, we believe the vast majority of insurers will successfully manage their Solvency II transition. This is another product of the post financial crisis balance sheet strengthening and enterprise risk management enhancement that has driven improved industry capital quantity and quality over recent years. We see Solvency II encouraging additional insurer restructuring, involving further efficiency gains and non-core asset disposals for example, as management teams look to optimise businesses to the new regulatory environment.

We expect investor perceptions of individual groups to alter as final Solvency II positions are revealed, with implications for bond relative value and pricing. We see insurers that have heavy exposure to the low yield environment as most challenged by Solvency II, in particular those life insurers in Germany, Switzerland, the Netherlands, Norway and elsewhere that sold material, long term investment guarantees and allowed significant asset-liability mismatches to develop.

We see greater Solvency II implications for insurance equity investors, especially those investing for outsized sector capital returns. Whilst we believe attractive equity returns are absolutely possible, stock selection is key given our expectation of strong regulatory oversight and conservative capital management. Emergence of Solvency II clarity will act as a key catalyst for prospectively stronger insurance equity investment performance.

Not surprisingly, the Solvency II framework and enhancement of regulation within the insurance sector has also contributed to the growth of the ILS universe. Broadly speaking, sponsors of Cat Bonds note the potential positive regulatory capital implications of this multi-year protection mechanism. Moreover, the risk transfer methodology offered through this fully collateralised cover benefits cedants due to a removal of counterparty and credit risk, and assures efficient access to capital during insured events.

Away from Solvency II, we continue to see potential for industry consolidation (as demonstrated by the recently announced acquisition of Chubb by ACE for $ 28.3bn), within the reinsurance and specialty line sub sectors, mainly focused on the London Lloyds syndicates and Bermuda based reinsurers. Within these industry segments, we see consolidation as a response to the alternative capital challenge to traditional reinsurance pricing, encouraging greater scale efficiencies and offering breadth amongst market participants.

Lastly, switching to hurricanes in the Atlantic basin, we are currently experiencing El Niño conditions with forecasts suggesting these will last and even intensify towards the end of the year. This points towards low 2015 Atlantic basin hurricane activity and, at the time of writing, there has been no hurricane event. However we would highlight that, firstly, the current absence of hurricanes is not unexpected given that peak Atlantic hurricane activity is usually in August and September and, secondly, low forecasts of hurricane formation do not necessarily reflect strong correlation with the number of hurricanes making landfall or insured losses. To illustrate, Hurricane Andrew occurred in 1992 which was an overall low activity hurricane season.


Private Insurance-Linked Securities

Private ILS taps into a variety of (re)insurance opportunities that are continuing to generate returns in excess of comparable Cat Bond securities. As these contracts generally offer 12 month protection to buyers, the premium earned above the return for traditional Cat Bonds is, to a large extent, due to the illiquid nature of the investments. This sub asset class provides a broad degree of diversification to ILS portfolios, resulting in exposure to harder to find natural peril regions, such as Australia or Europe, as well as access to man-made perils such as marine and fire.

In the Private ILS market, renewing a large part of our portfolios in January proved to be a wise strategic decision as, over the course of the last six months, there has been a continuation of spread erosion within the space. Yet, throughout the first half of 2015, capital markets reflected their pricing discipline by rejecting a number of Cat Bond issuances with less than favourable risk/return characteristics. This is often the first sign of a turn-around in the underlying reinsurance space and, at the time of writing, prices for industry loss warranties (ILWs) have stopped retreating, with some levels starting to improve.

We are positive on the Private ILS market over the second half of 2015, but not without reason. The ILS space has been shown to be a very sophisticated market, keen to collect the right premium over risk and continuing to use complex mathematical modelling to ensure pricing remains appropriate and that margins are not eroded. We expect to see a firmer market in the next six months of the year and, even without a significant event, believe that despite some suggestions of pricing declines, the next round of renewals will likely see pricing stabilisation within the Private ILS space.