Fitch Ratings recently described the global insurance linked securities (ILS) sector as “strong and viable,” with investors seemingly committed to the marketplace despite recent losses on individual deals.
The rating agency’s outlook is positive even as alternative reinsurance capital – including collateralised reinsurance, catastrophe (cat) bonds, sidecars, and industry loss warranty (ILW) contracts – has remained relatively flat for the past three years, at around $95 billion, according to Aon Corporation.
“This was after a meteoric rise [between] 2011 and 2018, where many people thought this alternative capital space was going to blow the top off the reinsurance space,” said Jeff Mohrenweiser, senior director at Fitch Ratings, who added that he’s not concerned over potential long-term stagnation of the alternative capital market. Rather, he said: “We think there’s opportunity for further growth here.”
Mohrenweiser described the flatness in the marketplace from 2018 to 2021 as a period of “realignment” where investors started to understand that losses do occur. He pointed to the historic natural catastrophe losses in 2017, which saw the HIM (Harvey, Irma and Maria) hurricanes in North America, and 2018, which saw hurricanes Florence and Michael. Following those events, a number of cat bonds paid out to sponsors, forcing investors to re-evaluate their support.
“On top of that, there was the historic number of named storms in 2020, which I think has led many people to think about climate change,” Mohrenweiser added. “And obviously, we can’t forget about the pandemic in 2020. An interesting phenomenon occurred there where the ILS market was holding up pretty well, and investors sold out of that at very good prices so they could go into more undervalued assets.”
All of these trends led to a re-evaluation of ILS fund managers, according to Mohrenweiser. He said: “Investors had to roll up their sleeves and do additional due diligence, and demand from ILS fund managers better communication, better reporting, better disclosure, and so, there was a slight culling of the herd there.”
One area of the ILS market that’s performing particularly well is cat bonds. According to Fitch, natural catastrophe bond issuance for 2020 reached an all-time high of $11 billion, beating the previous high of $10 billion in 2017. The group explained that investors rotated slightly out of collateralised reinsurance into the 144A catastrophe bond market, which offers slightly more liquidity and structure.
“Cat bonds tend to have a three- to four-year maturity, so in 2017 and 2018, there was near-record issuance at that time, and those proceeds – the bonds issued in those years – would have matured in 2020 and 2021. And what we’ve seen is that investors have stayed committed to the market and reinvested those proceeds despite the losses,” said Mohrenweiser.
In 2019, the investor capital base did take “a little bit of a pause,” he added, to reassess their positions and make some decisions, but they’ve since come back quite hard.
“This also probably reflects the general tone of the property cat space, where there is a hardening of the market,” Mohrenweiser noted. “Reinsurers and all players in here are now starting to get some price increases. It is a difficult process to get investors into the space, so with that long, onboarding process, hopefully investors stay committed to this marketplace and it sure looks like it.
“In [Q3] 2021, as we look at the market, the deals that are coming to the market have been oversubscribed, and the risk premiums are at the lower end of initial guidance, so sponsors are definitely benefiting from this increased capital demand.”
When the alternative capital market was impacted by heightened cat losses in 2017 and 2018, some investors were caught by surprise, and they quickly learned the meaning of concepts like ‘loss creep’ and ‘trapped capital’.
That caused “a little bit of angst,” according to Mohrenweiser, who said that “sometimes these [fund] managers cannot get a good handle around the insured losses that these cat bonds are covering”.
He explained: “This has led to trapped capital where maturity dates [for the] capital to be returned have been extended for a year, two years and even three years. I think it’s the uncertainty of when to get money back which has caused that pause [in new issuance] in 2019.”
The market did make some changes to address loss creep and trapped capital, with the introduction of parametric triggers, as opposed to the more traditional indemnity triggers.
Parametric triggers are binary, they’re agreed to in advance, and they’re based on transparent and objective data sources, such as government-backed catastrophic weather services. With a cat bond, for example, if a hurricane makes landfall, that could automatically trigger the bond.
“We also see a slight increase in per occurrence versus annual aggregates,” Mohrenweiser added. “Again, per occurrence is that any single event could trigger the cat bond, whereas the annual aggregate would be a series of catastrophe events, which trigger the bonds. And this was particularly acute again in 2020, with the increased number of names storms.”
When it comes to ILS, the “pendulum swings back and forth” depending on the overall trends in the reinsurance market and whether it’s a hardening or softening market.
“A number of bonds have paid money to the cedents, which is good. That’s what the market was set up to be,” said Mohrenweiser. “There are benefits and drawbacks. It shows that the market does work. It then allows other people to come into the market. It provides some legs to stand on. Obviously, no-one ever wants to lose money, but again, as long as the contracts are doing what they’re supposed to do, and fund managers are also doing what they promised, I think the market has a good basis or foundation to further grow.”