ILS could benefit from ESG prominence
Environmental, social and governance (ESG)-related considerations are becoming increasingly important to investors. As we outline below, the insurance-linked securities (ILS) asset class is naturally aligned with ESG principles and continued adherence to high ESG investment standards will not only accelerate ILS market growth, it will also ensure the long-term sustainability and attractiveness of the asset class for investors going forward.
Weather is one of the main risks underpinning investments in the re/insurance sector and as a result the ILS market—like the insurance and reinsurance market it supports—is at the forefront of monitoring changes in weather extremes and their impact on economies.
Every US hurricane catastrophe bond—the most well-known type of ILS instrument—has an indication of the risk of the bond, both with and without the impact of elevated sea surface temperature (SST), to assess the possible impact of climate change on hurricane activity.
Unlike long-duration investments such as equities, long-term bonds and real estate, ILS—with typical maturities ranging from one to five years—can reprice their returns in the relative near-term as new information about weather event frequency and severity becomes available.
In this way capital market investors are provided with a forward-looking, market-based indication of the costs of weather risks and therefore climate change. In return for providing capital to set against these risks, investors stand a chance of being adequately compensated for them.
ILS environmental considerations
Re/insurance losses are also driven by other environmental factors, such as the underlying insured exposure in harm’s way. In hurricane-prone areas for example, ILS provide a market-based indication of the long-term costs to society of coastal property development as well as the hurricane hazard. Better managed communities and infrastructure, all things being equal, should be rewarded with more competitively priced re/insurance risk capital than poorly managed developments more prone to larger insurance losses.
The same principle applies to urban development in seismic zones. This market-based pricing mechanism provides an important signal of the relative benefits of environmental risk mitigation and adaptation measures to communities and creates a powerful feedback loop that aligns incentives for better risk management in the long run.
Re/insurance and ILS markets are uniquely placed to provide this essential price discovery function to society.
ILS social considerations
The ILS market was born in the late 1990s after two events in the US—Hurricane Andrew in 1992 in suburban Miami and the Northridge Earthquake in 1994 in suburban Los Angeles—caused a near-collapse of the insurance markets in Florida and California. These disasters created an opportunity for capital market investors to provide new capital to the re/insurance sector and since then ILS have had an increasingly important role in stabilising insurance markets by broadening the mutual sharing of risks across a larger and deeper capital pool.
As an illustrative example, let’s consider Florida, one of the largest buyers of property catastrophe insurance coverage in the world. According to a June 2014 whitepaper from catastrophe modelling specialist Karen Clark and Company, “The 100 Year Hurricane”, the industry estimate of the one-in-200-year insured loss from a hurricane hitting major cities such as Miami is $250 billion.
At the same time, according to a 2019 AM Best report, “Reinsurance: Will Investor Losses Lead to a Rising Tide for Pricing?”, the total capital base of the traditional reinsurance industry is estimated at approximately $350 billion.
Although the reinsurance capital base is not all exposed to this single event, a one-in-200-year event would throw the global re/insurance market into disarray with significant impacts not just for the local population, but on the entire cost of insurance worldwide.
Fermat Capital Research estimates that in the aggregate, the entire global traditional reinsurance market covers only $40 billion of single-event loss in Florida.
ILS, in recent years, have grown to the point that they provide an estimated $50 billion of additional hurricane coverage to insurance companies and reinsurers active in the state.
Therefore, ILS have significantly helped spread Florida hurricane risk outside of the Florida insurance market, helping to reduce the economic impact of a major hurricane on the local citizens. Moreover, by helping to better manage Florida’s risk, ILS have contributed to the stabilisation of re/insurance markets globally so they can better support sustainable economic activity worldwide.
ILS governance considerations
ILS enable insurers and governmental entities to manage systemic catastrophe risks with an efficient, pre-event approach to disaster response—rather than an inefficient, post-event approach.
A key governance benefit of pre-event disaster response preparation is the increase in transparency, as well as accountability, of disaster relief funds. An unspoken dynamic of traditional post-event disaster aid is that the situation often needs to get worse before relief funds might be mobilised.
Even then, the amounts and conditions under which relief funds will be received are uncertain, making use of fund implementation plans difficult and inefficient. Therefore, pre-arranged financing with transparent triggers for funding flows greatly increases the efficacy of disaster financing and planning.
For example, guided by these pre-event financing principles, the World Bank Treasury, as part of a larger spectrum of risk financing services offered by the World Bank Group, has been enabling client countries to manage their natural catastrophe risks with catastrophe bonds that use so-called parametric loss triggers.
These triggers are based upon transparent and objective parameters of the event, such as magnitude and location of an earthquake, the central pressure of a hurricane or even the number of lives lost due to a specified disease.
Through its ILS platform—the MultiCat programme—the World Bank has been facilitating the issuance of hurricane and earthquake catastrophe bonds for the government of Mexico since 2009. Since 2014, it has directly issued catastrophe bonds for the benefit of client countries through its Capital-at-Risk Notes programme, including the 16 country members of the Caribbean Catastrophe Risk Insurance Facility, the Pacific Alliance member countries (Mexico, Chile, Columbia, Peru) and low-income World Bank country members facing pandemic risks.
These issuances are embedded in broader national disaster risk management programmes aimed at reducing the impact of disasters on economies. They include contingency planning for a faster, more predictable and more effective response to vulnerable communities as well as ex ante risk mitigation measures.
In our view this increasing trend of sovereign policies and actions for de-risking public balance sheets will form a significant piece of sustainable market growth in the future and a source of recurring risk transfer to the ILS space.
ESG investments
As illustrated by the examples above, we believe that ESG factors are central to the long-term investment proposition and performance in the ILS asset class. They will create opportunities that enable the market’s future growth, while providing incentives to ensure investments are adequately and sustainably priced.
At Fermat, ESG principles for investing are intertwined with our ILS underwriting process, and are essential to the composition and ultimately to the growth and performance of our portfolio. Adherence to these principles in traditional ILS underwriting more broadly will also ensure these standards are maintained and improved further.
Through the lens of governance, for instance, transparency is emphasised in how loss triggers, loss modelling and risk factors are defined and disclosed in ILS submissions. In a catastrophe bond, for example, these elements are presented in the offering circular of the security at issuance.
A cat bond is officially an investment in a special purpose insurer (SPI), which is a company established for the sole purpose of issuing the ILS. Investors will focus on and scrutinise the governance of that SPI—as detailed in the offering circular—before making a decision to invest.
The quality of this material has a great deal to do with the quality and transparency of the reporting by the re/insurance company sponsoring the SPI and the cat bond issuance.
Avoiding investments with bad risk disclosure practices and bad loss trigger designs therefore sends a strong message to companies seeking to access the ILS market as to the corporate governance standards that are required and rewarded by investors.
ILS play an important and growing role in managing the world’s most pressing risks. The attractive risk-adjusted returns of the asset class reflect this valuable contribution to the security, stability and growth of the global re/insurance market and therefore the benefits it brings to economies and societies worldwide. We believe that the natural and continued alignment of ILS with these positive ESG attributes will further protect and enhance portfolio returns for investors as the asset class grows in the years ahead.
