A flight to quality is underway in the insurance-linked securities (ILS) market, following disappointing performance in 2017 and 2018, an exclusive Bermuda:Re+ILS survey has revealed.
Only 9 percent of respondents said there was no flight to quality among investors, compared to 55 percent who saw evidence of one, leaving a significant number of people undecided on the matter.
One respondent suggested the flight to quality would prove a permanent feature.
“Institutional investors crave yield in a zero interest rate (or near) policy environment, especially when it is a diversifier. That appetite will finally drive insurers, or more likely their successor institutions in the food chain, to learn to quantify a far wider range of low beta risks in the economy,” said the respondent.
The respondent added: “Institutional investors, just like insurers past, will chase non-quantifiable risks (cyber, terror, credit) in their lust for revenue. This always ends badly.”
Another respondent acknowledged the flight to quality was real, but described it as “a temporary pause”, and predicted it would return to “the longer growth trajectory”.
After the gruelling years of 2017 and 2018 investors can be forgiven some pessimism around ILS, but the mood music in the market is actually surprisingly upbeat, considering the losses investors have taken in recent months.
In a note on its website Willis Towers Watson (WTW) compared the ILS market to “a boxer whose reputation isn’t fully established until faced with a full-blown strike to the chin”. In that sense the last few years have not been an existential crisis for the industry so much as a baptism of fire, or the ultimate stress test, says WTW.
“Many insurance industry commentators have waited to see how the ILS market will react to current market conditions,” says WTW. “A costly 2017 natural catastrophe season—far from causing it to go down for the count or contemplate throwing in the towel—has, if anything, reinforced the market’s attractions for many of its participants.”
An S&P Global Ratings’ report in June, titled For Global Reinsurers, 2019 Pricing’s Green Shoots Look Promising, painted a similar picture. It predicted the ILS market will bounce back from the recent drop in interest. It said that following disappointing reinsurance pricing increases in 2018 and early 2019, it seemed that no amount of catastrophe losses would be sufficient to harden the overall market.
S&P suggested that reinsurers had seen some green shoots of recovery during April and June renewals for 2019, with property catastrophe rate increases in the 15 to 25 percent range on loss-affected accounts.
The logic for alternative capital investors is compelling. Investors are always interested in any asset class that is uncorrelated to the bonds and stocks that comprise the majority of portfolios, especially when they are transparent and easy to understand. While no-one wants to suffer losses in their portfolio, it is at least understandable when the losses relate to a force of nature like a hurricane.
This explains why the market kept growing despite the calamitous year in 2017 when hurricanes Harvey, Irma and Maria caused a reported $91 billion of insured losses in the US alone, according to the Insurance Information Institute.
In 2018 around $9.2 billion was placed in new cat bond issuance, according to WTW. “Nearly two-thirds of end investors surveyed invested in ILS for more than five years,” WTW adds, demonstrating the loyalty of this investor group.
Issuers do not appear to be deterred. In late June Liberty Mutual issued $135 million of 2019-2 Notes on the Bermuda Stock Exchange via its Limestone Re platform, unlocking reinsurance capacity for its US property catastrophe programme and global treaty property reinsurance business.
“Many insurance industry commentators have waited to see how the ILS market will react to current market conditions. A costly 2017 natural catastrophe season—far from causing it to go down for the count or contemplate throwing in the towel—has, if anything, reinforced the market’s attractions for many of its participants.”
Investors also remain committed. Twelve Capital, which has historically managed several ‘white label’ cat bond strategies for private banks in Switzerland, has changed its strategy to develop its own range of products under its own brand, with funds investing in cat bonds and collateralised reinsurance, as well as in its multi-asset best ideas strategy. The fund manager reported growing interest in ILS from investors across its core markets of Switzerland, Germany, France, Benelux, the Nordics and the UK, but expects growing interest outside those markets too.
Yet clearly investors have had to overcome a challenging time in the ILS market. Significant price weakness in the secondary cat bond market in particular has weighed on many funds. US dollar shares in the open-ended ILS Diversified fund were up 1.27 percent year to date as at the end of May, although they had lost 0.13 percent in May itself—the second month of negative returns this year.
Dollar-based investors in the fund must have been grateful to be in positive territory at all after the rollercoaster ride of the previous two years. In 2018 it was down 8.08 percent for the year, while 2017 was even worse, with returns of -12.34 percent.
The Swiss franc share class fared even worse. In 2019 the Swiss franc class lost 0.26 percent in the year to May, having returned -11.14 percent in 2018 and -15.26 percent in 2017.
Crucially, however, and unlike in some other, more complex asset classes, investors appear to understand the risks they have bought. Around 80 percent of ILS investors surveyed by WTW reported that ILS fund performance was in line with their expectations in 2017, given the scale of natural disasters. This makes losses more palatable.
Against this backdrop, S&P characterises the current global reinsurance pricing environment as a hardening market rather than a hard one.
Reinsurance pricing assumptions were challenged by continued loss creep from catastrophe losses in 2017 and 2018, according to the WTW report, and alternative capital, including ILS and collateralised reinsurance funds, were not spared.
According to Swiss Re estimates, alternative capital represented about 25 percent of total property catastrophe risk supply in 2018. In addition, alternative capital accounted for 25 to 30 percent of the insured losses from the 2017 North Atlantic hurricane season.
Growth has slowed because of dismal returns and spread-widening in high-yield corporate bonds, exacerbated by governance issues at certain funds, which triggered investors’ redemption requests.
“This has caused a flight to quality, as investors shifted their attention to well-established sponsors/managers with a better track record,” says S&P.
“However, despite the recent developments, we still believe alternative capital backed by long-term investors remains committed to property catastrophe risk and is here to stay.”
Arno Gartzke, vice president and director of ILS at Liberty Mutual notes Limestone Re placements had performed strongly relative to the broader ILS market throughout 2017 and 2018, suggesting investors are indeed gravitating towards certain trusted issuers.
James Slaughter, executive vice president and chief underwriting officer of Liberty Mutual’s global risk solutions business, says: “Third party capital will continue to be a growing presence in the re/insurance market.”
Standard and Poors, Willis Towers Watson, Twelve Capital, Swiss Re, Arno Gartzke, Liberty Mutual