The life ILS market is a multi-faceted one, providing an array of opportunities for both institutional investors and asset managers to participate in the space. Life Risk News’ Greg Winterton spoke to Craig Gillespie, Head of Life and Alternative Credit Portfolio Management at Leadenhall Capital Partners, Scott Mitchell, Head of Life ILS, Portfolio Manager at Schroders and Gokul Sudarsana, Managing Director, Chief Actuary at Hudson Structured Capital Management to get their thoughts on the current state of the market.
GW: The life ILS market provides for a wide array of investment opportunities. How do you view the opportunity set? What are your areas of focus?
CG: Leadenhall has been providing insurance linked investment strategies for 15 years and in that time, our investment activity has encompassed all of the major life and health insurance markets.
At present we see a wide range of compelling investment opportunities. There is a general scarcity of capital across all investment markets, and we see the current environment as being an opportune one for capital to be better rewarded through both increased return and more remote risk profiles.
SM: Yes, that’s right – the life ILS investment universe can be quite nuanced and can mean different things to different investors. Schroders’ primary focus for life ILS has always been the structured life insurance financing trades, such as Value of In-Force financing arrangements relating to underlying blocks of life insurance. We have a secondary focus on more traditional life insurance debt financing as well as investments into pure risk transfer instruments relating to mortality or morbidity.
GS: Life ILS has several flavours – asset-intensive, biometric, commission factoring, life settlements, etc. We see the most value today in asset-intensive opportunities – investing in blocks of life insurance and/or annuity business that require significant reserves and running that off over a period of time – because it is a highly cash generative business model with diverse sources of earnings.
I think this subsector is sometimes overlooked in the life ILS conversation, since, as the name suggests, there is of course an asset risk component to the overall return profile. Some of the more traditional life ILS themes are designed to isolate just the insurance policy risk per se, and that certainly has its own merits, but life insurance, by nature, is a longer duration product. As such, investment income will always be a key part of the overall return. When seeking to carve out asset risk in pursuit of a pure insurance policy-related investment, you can miss out on – or worse, not properly underwrite for – core earnings streams to service your capital.
GW: Most alternative investment strategies, including life ILS, are facing capital raising challenges due to higher risk-free rates; the life ILS space now needs to deliver even higher returns to maintain the spread. How has the elevated interest rate environment impacted your approach to asset raising?
SM: With the rising rate environment, many investors have become overweight with their illiquid asset class allocations, which has influenced their appetite to add to existing illiquid exposures. We’re seeing that effect globally, with a pronounced effect in specific segments such as the UK pension market, where improved funding positions means there is greater scope to consider a buyout solution and there is generally less liquidity following the mini-budget fallout last year.
All this being said, the core life ILS proposition remains attractive and that message hasn’t changed much. While there is reduced appetite from pension funds, which was historically the main source of capital for life ILS, we find ourselves speaking to different segments of the capital markets who are now looking at the space. The different perspective of those segments can result in a different discussion.
GS: A key objective of ILS generally is to access uncorrelated returns, and the recent turbulence in the broader capital markets has presented the opportunity for the industry to demonstrate that, and ultimately attract more capital. Within life ILS, it may sound intuitive to think asset-intensive life investments would be more correlated than some of the other themes, but the business is well-insulated from most capital markets risk because of tight ALM and strong credit quality. In fact, a well-managed asset-intensive block actually benefits from a rising rate and widened spread environment, since that expands net interest margins. On the other hand, the effect of rising rates on lapse behaviour has challenged some other life ILS products. So, from a returns perspective, asset-intensive acts as a natural inflationary hedge that can support the higher return rates some allocators are looking for.
I would also add that there continues to be a robust bid for the asset-intensive blocks themselves, that has kept pricing fairly inelastic despite rising rates. I would point to two drivers. First, there is a secular shift of life and annuity blocks being acquired by asset managers, because the stable, long-term, low-cost funding provided by the reserves is highly complementary to their credit capabilities. And second, there is growing interest from long-term institutional capital – pension plans, sovereign wealth funds, Japanese financial institutions, etc. – that values the stable cash flow profile.
CG: There’s certainly been an upending of the macro environment that had prevailed since 2008; the era of the Zero Interest-Rate Policies (“ZIRP”) has now ended. Low rates were a big driver of institutional investors including pension funds turning to alternatives during that period as a way to boost and diversify overall portfolio yields to help meet the cost of their liabilities. That strategy of allocating to alternatives worked out well for many of these institutional investors in the post-2008 period. Now that central bank interest rates are up to 5% in certain markets – historically higher than any point in the past 20 years – a lot of institutional investors such as pension funds are now well funded and so this has reduced their short term need for alternatives.
From our perspective life ILS has always been a specialist investor product – it’s not something that is “bought off the shelf”. Sophisticated institutional investors that have done the work can still see a compelling rationale, especially those with a medium to long term investment time horizon that continue to see value in diversification and the opportunity to capture illiquidity premiums.
Another consequence of the changed macro environment in the last couple of years is a reversal of any potential spread compression from broader generalist investors. Generalists did start to creep into the space during the late stages of the ZIRP period, but now, with central bank interest rates reverting to historic norms this has had the effect of flushing out the generalists from the space. We see spreads as especially attractive at the moment relative to the last 10 years, but certainly, the case for allocating to alternatives is a tough one to bridge for many investors right now with other simpler more liquid markets also offering attractive absolute returns.
GW: This time last year most of the restrictions imposed by governments due to Covid-19 had been lifted. Now that we’ve had a year of something resembling normality, what’s the current state of the impact of the pandemic on longevity and mortality risk investing?
GS: In asset-intensive, the market dislocation caused by Covid in March 2020 certainly paused deal activity temporarily. The public equity market was particularly punitive to life insurers, and that perhaps accelerated their thinking on divesting legacy reserves and pivoting to a more capital-light business model. That was followed by a period of quantitative easing through 2021 which made for an attractive environment for buyers to acquire blocks with low cost of funds. As rates have since steadily have moved up since 2022, margins expanded. The block market certainly cooled off in 2022 after a very busy 2021, but has picked up again in 2023 as the new rate environment seems to be settling in.
I would also add that primary sales, in both life insurance and annuities, have been strong since the pandemic.
CG: Over time our investment activities have been closer to the mortality risk investment side given the nature of our investor base. Mortality risk was stable for quite some time in the developed world during the pre-Covid era, however post-Covid it appears that we have entered into a more uncertain environment in terms of mortality experience. Excess mortality effects in recent years were initially being directly attributed to Covid incidence but now that we’re a more than a year on from when lockdowns were fully lifted excess mortality has remained present in certain age groups and geographies around the world. There are a range of reasons for this excess mortality: individuals not being treated for other health issues during Covid, and the continuing opioid epidemic in the US, for example.
The impact of this excess mortality has fed through into the ILS markets with it being publicly reported that certain mortality risk transfer instruments are at risk of being triggered, leading to potential losses for investors. These mortality risk instruments are, by their design, exposed to excess mortality events, however triggers being met on these will force some reflection and thinking in some parts of the investor community. In this post-Covid era we are treading more carefully when assessing mortality exposed investments as we seek to navigate the volatility in realised mortality rates.
The flip side to this volatility is that we observe increased demand for coverage as these excess mortality events and Covid itself has emphasised the potential benefits of mortality risk transfer. From a risk taker perspective, we are proceeding cautiously, to ensure that the risks being transferred to investors are priced correctly.
SM: We have historically focused more on mortality than longevity, so specifically in that space, we’re still seeing mortality rates running at excess levels in the main markets we operate in – particularly, excess mortality in the working age groups.
What’s making mortality modelling trickier is that the causes of excess mortality appear to vary by territory; it looks quite different in the US and UK, for example. That makes it more difficult to quantify the risk and naturally makes us more cautious when we’re looking at prospective mortality-linked investments.
GW: Still on the deal space: the life ILS market exhibits the irresistible force paradox because insurers don’t have many places to turn for financing options, but higher rates bring a lower appetite for deals. Which of these is winning out at the moment and why?
CG: It almost splits into those counterparties that have a firm need to finance and those who have the capacity to wait. This is a consistent dynamic with other industries whereby individuals or institutions that have the capacity to, defer major economic decisions until the environment is more certain for them.
Life insurance companies are, in general terms, benefitting from the higher interest rate environment, and so now may be a compelling time for life insurers to make strategic investment decisions. These strategic decisions often have associated financing needs, and this may be a driver of continued financing deal flow for the life ILS space. The higher interest rate environment may make absolute financing costs more expensive than they would have been in the past and this will be considered when assessing overall profitability of the strategic transaction that the life insurer may be considering.
SM: From our perspective, the sponsors of transactions are adjusted to the reality that we’re not in the ultra-low interest rate environment anymore. As rates were starting to hike there was perhaps an initial reluctance by deal sponsors to transact at higher rates, but now I’d say that the market has adjusted. And from our perspective, there is a strong flow of deal opportunities and spreads have been resilient, and that situation has probably benefited from the general tightening of liquidity across the broader markets.
GS: In a low-rate environment, buyers of asset-intensive blocks will assume lower prospective net interest margins and so need more upfront value to meet their return targets – i.e., lower purchase prices or lower ceding commissions. This generally limited the deal space to simpler, cheaper liabilities that are adequately reserved for; otherwise, sellers would have to have accept significantly higher upfront costs to clear the market. With higher rates, that paradigm reverses, so that has made complex, higher-cost products more addressable. For example, we’ve recently seen a number of Secondary Guarantee Universal Life blocks transacted that were previously challenging.
GW: In the UK, there is a lot of coverage in the news media about inflation and the cost-of-living crisis and the impact on consumer discretionary spending, which could feed into life insurance. Are you seeing changes in lapse rates in both the UK and other markets, and if so, how are you navigating that?
SM: The affordability of premiums can influence lapse experience on a block of life insurance policies but there are nuances here. Lapse rates can vary quite significantly by the type of life insurance product – for example, a savings product will behave differently to a pure protection product. But the financing structures that we put in place are typically structured conservatively and can absorb a significant lapse stress before it impacts invested capital. We’re not seeing material impacts from lapses that are causing us any concerns. But again, that’s because we adopt a conservative approach to structuring these transactions.
GS: In terms of managing lapse risk generally, we think about product design, business mix, asset/liability matching, and liquidity. Diversification among non-lapsable, lapse-supported and lapse-sensitive products helps stabilize your liability base, and to the extent there is lapse-sensitive business, focusing on product design to ensure strong surrender protection. Additionally, paying close attention to cash flow matching, and ensuring appropriate access to liquidity, will allow you to service any excess lapses without potentially being a forced seller of assets to raise cash.
This goes back to my earlier observation on the diverse earnings profile in asset-intensive business. In a pure lapse trade, rising rates can drive up lapse experience and impair returns whereas in asset-intensive, a well-managed book of business actually benefits from rising rates, so it’s a compelling way to participate in lapse risk.
CG: At present, in the markets we are active in, we do not perceive this as a meaningful issue. Lapse risk has always been a more volatile peril – it’s not as stable a performer as mortality risk. The latter is a biometric peril with inherently more stability than a behavioural peril such as lapse risk. During Covid, people were worried about having life insurance in place in case the worst were to happen, and this was reflected in lower lapse rates, so it was a good time to hold lapse risk. As society has readjusted to life post Covid it would be reasonable to assume that there would be some mean reversion occurring in lapse rates, but nothing is jumping out to us specifically at present.
It’s also important to note that lapse risk differs by product line. Many life insurance products have explicit disincentives to lapse such as surrender penalties and clawback periods where it may cost the policyholder to cancel. There are also inherent disincentives to lapse as if an individual lapses their policy, they are likely to have to be re-underwritten which could lead to a reduction in available cover or increased premium cost to obtain the same level of cover as before
GW: Aside from lapse rates, what are some of the other challenges that the life ILS market faces as we look to the next 12-18 months – and on the flip side, what about the opportunities?
GS: In asset-intensive, I would say the key focus areas are pricing discipline and heightened focus on ALM, liquidity and credit quality. As mentioned earlier, buyers can expect higher asset yields in this environment to support higher cost products, but it is critical to lock in those net interest margins so you’re not exposed to reinvestment risk if rates fall and therefore stuck with a high cost of funds you can no longer cover. Similarly, the spread environment is also attractive in supporting asset yields, but you’ll need to ensure that the underlying credit quality does not deteriorate.
I think there is a great opportunity in the pension risk transfer market globally. If you consider how pension funding has evolved over the last decade, we can expect to see a lot of volume transacted in this space (and already are seeing this). Pension funding status was generally impaired by the global financial crisis given substantial equity allocations. The subsequent equity bull market helped replenish the asset side, but the protracted low-rate environment kept liabilities high. Now with rising rates, those liabilities have come down and funding ratios have improved into a transactable range. When you then overlay a potentially challenging corporate credit environment, it creates a compelling opportunity for corporates to de-risk their balance sheet via pension risk transfer. Meanwhile, the insurance market is also keen to assume these liabilities as a source of low-cost, persistent funding, so we anticipate attractive capital opportunities to support this demand.
CG: It’s important to remember that all markets exhibit some form of cyclicality. Whilst the last couple of years have been tumultuous from a macroeconomic perspective, we continue to focus on a core message around why these strategies should be compelling for investors as part of their medium to long term investment portfolio planning.
Practically this means that is a case of steering our existing portfolios through the current environment and, when in discussions with potential future investors, making the pitch as to why an allocation should still be on their agenda when these investors are presented with other opportunities that may appear more compelling in the short term. Understanding where the likely next flows of capital are coming from – that will form our capital base in the next few years – is a focus area for us.
SM: I’d say the main challenge is probably around the reduced appetite in the capital markets for illiquid asset classes – it may take time for existing exposures to reduce naturally before we see similar levels of appetite that we saw prior to interest rate rises. We also anticipate a slowdown in mortality trades due to the ongoing uncertainty and difficulty in quantifying mortality rates.
On the flip side, we continue to maintain a primary focus on the financing trades, where the risk return profile – low volatility, excess spreads, and low correlation with broader capital markets – remains attractive compared to comparable asset classes. We think that remains attractive to investors relative to other comparable asset classes.
Craig Gillespie is Head of Life and Alternative Credit Portfolio Management at Leadenhall Capital Partners
Scott Mitchell is Head of Life ILS, Portfolio Manager at Schroders
Gokul Sudarsana is Managing Director, Chief Actuary at Hudson Structured Capital Management
The views expressed in this article are those of the individuals