Flexible capital & funding models like ILS can proliferate: Bain & Company

Insurance-linked securities (ILS) get a brief mention as a potential area of growth in finance that could “proliferate” as the world deals with a scenario where demand for investment surges, but supply and mobility slows down, in a paper from Bain & Company.

Global consultancy Bain & Company believes that in the currently turbulent world, financial capital flows, how capital moves and where to, are destined to change.

There is a need to have capabilities around “future sensing” in order to recognise patterns and develop options, to capitalise on opportunities, a new paper from the consultancy explains.

Greater flexibility is going to be needed to navigate the new landscape that is emerging, Bain & Company says, with changes in financing one of the expected trends that will emerge and perhaps already is in certain markets and industries.

“Financial markets… face profound change as debt burdens reach levels that historically have proved to be unsustainable. In recent years, low interest rates eased these debt burdens while inflating a broader range of asset bubbles as global financial capital has more than tripled over the past three decades to roughly 10 times global GDP. Now, the current environment, with both higher inflation rates and higher real interest rates that are expected to remain elevated, will likely reverse this dynamic,” the paper explains.

As a result, Bain & Company predicts a slower growth of financial capital as a major trend that is reshaping the business environment.

Global capital formation is expected to slow, as “populations age and shift from net savers to net consumers,” Bain says.

This is even as the demand for investment increases, so the consultancy is not expecting a slow in appetite to deploy capital, it seems.

They call the emerging trend “capital rationalization” and say that the effect of this could even prove more severe in a post-globalized world with more fragmented capital markets.

Higher costs of capital are also highlighted as an issue for some sectors, all of which could play into a multispeed world.

“As demand for investment surges and global capital formation and mobility slow down, securing the right forms of capital from the right investors at the right cost will become more difficult,” Bain warns.

Further explaining, “The recent rise in interest rates alone has changed the equation on how to balance current profitability and future revenue growth. In a world where the cost of capital was less than 6%, as in much of the past 15 years, future revenue growth was up to three times more valuable than current profits; at 9% cost of capital, the value of profits today will be the same as that of future growth, and at 12% cost of capital, the value of profits today will be five times that of future growth.”

But the trends that are emerging still offer “enormous value creation opportunities”, while Bain also notes that, “investors will have the power to be more discerning about what they fund and more demanding about the rigor of business-building capabilities required.”

Sources of funding could become more globally dispersed and also less geographically mobile, while funding sources could also become more diversified by type of institution, Bain forecasts, with geopolitics a driver as well as the retrenchment of some traditional financial intermediaries in the face of increased regulatory requiremnts.

However, it’s not all bad in capital markets, by any means and Bain also points to areas of promise and opportunity.

Which is where insurance-linked securities (ILS) get their brief mention.

“Flexible capital models such as green bonds, blurring private-public ownership structures, and even vehicles that let investors fund specific projects, such as insurance-linked securities, will likely proliferate,” Bain & Company states.

Bain calls for companies to “devise creative balance sheet options,” something that the use of insurance-linked securities (ILS) has already provided to traditional insurance and reinsurance companies, in bringing aligned and flexible capital in as risk funding from global third-party investors.

In addition, direct corporate and sovereign sponsors of ILS, such as catastrophe bonds, are effectively creating new flexible capital models and being “creative” with their balance-sheets in the face of, and to better manage, their risks.

In fact, ILS is really all about creative and flexible funding of risk, disrupting existing capital models and augmenting balance-sheets to enhance them.

It’s interesting to see one of the largest consultancies in the world highlight insurance-linked securities (ILS) in this way, even as just a small mention in a much broader, very thoughtful and forward-looking paper.

It reflects the growing stature of ILS and the fact those with a focus on the business and capital models of the future, have one eye on this market as a sector that already exhibits some of the features of how they expect markets and companies to evolve over time.