The alternative credit industry experienced something of an up-and-down year in 2023. On one hand, fundraising pulled back as investors rotated into more liquid, higher yielding credit investments, and on the other, existing funds, particularly in the private debt space, with floating rate loans enjoyed higher returns.
The impact of higher interest rates was certainly felt keenly in the life ILS corner of the alternative credit space last year, in both capital raising and deal activity. In the former, the reasons were consistent with the alternative credit market at large.
But in deal flow, certain trades experienced a retraction in activity. One example is value in force (VIF) deals, a transaction where asset managers pay a discounted upfront cash sum to an insurer in return for the payment stream of a block of insurance policies.
“The rise in interest rates in conjunction with a widening of risk spreads has led to higher absolute costs of financing which has presented challenges to investment counterparties. That higher cost of financing has an impact on the appetite for certain VIF structures because sellers and suppliers of risk are having to pay more than in the past. Some counterparties are questioning whether or not they’re comfortable printing at the top of the cycle,” says Craig Gillespie, Head of Life and Alternative Credit at investment manager, Leadenhall Capital Partners.
But whilst there may be a contraction in the supply of VIF transactions, higher rates are providing an opportunity for managers in the space to be more selective with regards to the deals that they do underwrite.
“Insurance businesses that still have a need for capital or liquidity have had to pay up the increased all in rates of financing. There’s been something of a flight to quality, where we’ve focused on working selectively with the best counterparties and pipeline opportunities in the market – there’s the opportunity to earn an increased spread whilst taking less risk than in recent periods. We’re being more prescriptive in terms of where we allocate capital,” added Gillespie.
In January, the US Federal Reserve kept its Federal Funds Rate flat for the fourth consecutive time, and the European Central Bank’s three main interest rates also remained constant. The UK’s Bank of England hasn’t increased its Base Rate since last August. Couple this with falling inflation adds up to encouragement in consumer and political circles that the recent rising interest rate regime has plateaued. But, even if markets are now at the top of the interest rate cycle, and at some point this year, interest rates began to fall, the floodgates won’t necessarily re-open.
That’s because both the Covid-19 pandemic and the recent macroeconomic environment have had something of a longer-term impact on the life ILS market, conspiring together to force investors in the market to re-evaluate certain aspects of their deal origination function.
“Covid underlined the fact that, from an actuarial perspective, populations are not created equally. During the pandemic, certain socio-economic groups were impacted by excess mortality more than others. General population mortality-based investment structures haven’t fared very well in the past few years, which means that our underwriting efforts are being further refined according to the underlying population exposure,” says Gillespie.
Recent macroeconomic events and the stronger volatility and uncertainty have also had an impact on how insurance companies approach capital solutions.
“In general, we see a strong increase in derisking and capital management activity in the European life insurance landscape. The bulk of the risk goes to the reinsurance industry but clearly Life ILS can play an increasingly relevant role moving forward. Whereas in the past the role of Life ILS was predominantly on the financing front, the end investors often now require ILS managers to revert to more biometric risk-driven investments or, ‘back to basics’ as they like to say,” says Luca Tres, Head of Strategic Risk and Capital Life Solutions, EMEA at insurance consulting firm, Guy Carpenter.
However, there is still, and will always be, appetite for financing solutions from the life insurance segment.
“Sitting in-between capital markets and the life (re)insurance industry, the Life ILS market introduces a differentiated capacity in the financing space, specifically for opportunities with a strong biometrical or lapse component. Therefore, it is clear that Life ILS will continue to be a strategic partner for the life (re)insurance industry”, adds Tres.
There’s a saying in the family office space that when you’ve met one family office, you’ve met one family office. The same could be said for the life ILS industry; not all asset managers enter into the same types of transactions, leading to less homogeneity within the space when compared to, say, the non-life ILS catastrophe bond market. The complexity of insurance-linked transactions when compared to other alternative credit strategies means that investor education is ongoing, and macroeconomic cyclicality has impacted the space like it has many private markets strategies.
But for Gillespie, the lessons of the past few years will prove beneficial in the medium to longer term, and overall, the message to investors remains.
“The life ILS space has actually been around for many years, but for the first 10, it was a relatively benign market. We’ve had two major tests in the last five years that have put certain investment structures to the test. These tests have helped the life ILS market to understand where the true risk premiums should lie, and whether these are aligned to the actual losses that could materialise when an event happens,” he says.
“This development in itself hasn’t changed the investment case for life ILS. The demand from life insurers and other life-linked insurance businesses for financing solutions is there. The supply of capital is there because investors need and want medium to long-dated exposures that offer differentiated risk-return profiles to the main capital markets. If anything, the events of the past few years have served to strengthen the offering by making the investment processes that underpin it more robust.”
