Our recent Willis ILS Report focused on current market trends. What came to market last quarter? . . . deals not exposed to U.S. hurricane risk. What we expect will happen in the next few quarters? . . . robust issuance. What are some of the issues to watch? . . . pending regulatory changes, growth of private deal alternatives. The report focused mainly on the concrete.
A less concrete issue is the market impact of investor fund flows. Stated simply, more cash means lower spreads and increased capacity. Less cash means the reverse.
Investor fund flows explain a lot. For example, they partially explain the spread spike following the financial crisis. Some hedge funds lost money on other investments and had to liquidate ILS (Insurance-Linked Securities) to fund redemptions.
Specialist Investors – A Special Case
The fund flows story is particularly important in explaining how dedicated “specialist” ILS investors behave. These investors make up half of the order book in many transactions. Fund flows can have a major impact on their deal appetite. Most specialists want to keep some cash on hand to make new investments. If they keep too much cash, the excess cash dilutes returns. If they have too little cash, fund redemptions can force undesirable asset sales, which may also dilute returns.
Over the past few years, specialists have had substantial net inflows. So far this has created both opportunities for complementary products (e.g., increasing support of collateralized reinsurance deals) as well as providing ample capacity for new cat bonds (especially for ex-US hurricane deals).
Connection to Market Structure
Besides providing a partial explanation for short term market trends, fund flows raise an important but as yet unanswered question: how can the ILS market evolve to both meet sponsors’ needs and address investors’ concerns about managing fund flows? Helping investors minimize uninvested cash and access liquidity, may help them attract more cash. Steady market growth resulting in a deeper and more liquid market will facilitate this naturally. Perhaps new products can also play a role in accelerating a more favorable environment for cash management.
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In sum, the next time you see ILS market commentary, ask yourself: What role do fund flows play? It might shed some further light on what is going on.
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