ILS and the effects of the COVID-19 crisis

What impact do you expect the COVID-19 outbreak to have on ILS?

The general cat bond market is not seeing a direct impact from the COVID-19 pandemic as the predominant underlying risks are natural catastrophe perils resulting from losses to property such as earthquakes, hurricanes and wildfires.

There has been an indirect knock-on effect of forced selling to free up cash in other parts of sellers’ portfolios which has mostly reported to be multi-strategy funds, but perhaps also more liquid cat bond-only insurance-linked securities (ILS) managers.

Although pandemic bonds have been a topic of discussion for many years, there has never been a substantial market for such coverage. One notable foray into the pandemic cat bond market was done by the World Bank in 2017. The bond was designed to help fund the response to any widespread outbreak of a number of diseases, including coronavirus.

The $320 million bond was part of a bigger $425 million risk transfer that included a concurrent $105 million swap with six reinsurance counterparties.

It is expected this bond will experience losses related to COVID-19 although there has been some discussion around the triggers that will lead to a payout to affected communities.

ILS related to cat bonds in particular are not expected to be seriously affected by the pandemic, demonstrating the non-correlation benefits in times of broader financial market distress.

In the immediate term—with, at the time of writing, a quarter of the world’s population on some form of lockdown—social distancing and working remotely are top priorities. The Bermuda Stock Exchange (BSX), insurers and reinsurers, ILS funds and their service providers have robust business continuity plans in place in order to limit impact to business interruption from events just as we are experiencing now. The nature of the industry is, after all, underwriting, preparing for and recovering from disasters.

As a result of COVID-19, the ILS industry in Bermuda and other locations were quick to respond with a number of measures to manage exposure to, and the fallout from, the pandemic. This included travels bans, limiting the size of meetings and initiated remote working and strengthened IT solutions to accommodate remote business activity and teleconferencing.

While from a broader perspective it’s “business as usual”, in the market it now seems clear that some investors face liquidity issues due to portfolio losses from other correlated assets. And with protracted market volatility and uncertainty, there may be an increase in liquidations from ILS positions in order to generate liquidity.

This scenario would not be a result of fundamentals or performance of the ILS asset class. However, what is happening now is reminiscent of 2008 when investors liquidated their ILS positions to raise cash. Then, as now, there are investors with the capital and appetite to take on these bonds at a discount.

Cat bonds have been trading at a minor discount to fair value—the perception is that as an asset that has held value through the turmoil, they are providing a source of liquidity to non-ILS specialists. With the new capital entering the existing market, new placements may be less likely in the next few weeks and new sidecars will struggle to attract investors.

As the ILS market has matured over the past few years, there continues to be interest from potential new investors who seek the non-correlating features of the asset class. The impact on the ILS landscape in the coming few weeks and months will be very fluid and hard to predict while this pandemic continues to spread.

Undoubtedly, we can also expect to see a resurgence in the interest in pandemic bonds.

What role can ILS have in tackling such a completely unprecedented macro-level challenge?

COVID-19 has caused unprecedented volatility in the financial markets despite, and sometimes because of, measures to stabilise monetary flows by various federal and government agencies. The quantitative easing by the US Fed stimulus package is a good example. The financial markets have not seen the current level of volatility since the financial crisis of 2008.

For macro-level or global challenges such as COVID-19, which have a big impact on capital markets, the link to stable products offering risk transfer without taking balance sheet risk could create opportunities for structured products impacting global challenges such as climate change.

While not all cat bonds have environmental social and governance (ESG) features, a growing trend is for ILS products to be utilised by governments and companies to increase resilience to macro-level exposures. These solutions could take a variety of forms from parametric covers for pandemics, to cyber risk and terrorism which builds stronger and more resilient economies.

The required operational and business certainty has caused the market to adapt business activity from less face-to-face interaction to other forms increasing utilisation of technology and less travel.

We should see the continued importance of effective investor relations, communications and information as well as the desire for transparency between market stakeholders.

Is this likely to impact issuance across the board, or in specific classes of ILS?

Due to the interest and demand for non-correlated asset classes, especially in times of increased financial market volatility, in the medium term we expect to see more capital enter the ILS market from investors such as pension funds and sovereign wealth funds with sensitivities to volatility and low interest rates.

There may be a short-term trend of redemptions from ILS managers so that investors can rebalance their portfolios—likewise, cat bond issuance could be pared back in the short term due to higher spreads.

Specific classes of ILS with non-correlated risk perils will remain attractive and demand may increase to replace lost or trapped capital. In the longer term, investors may see an opportunity for upsizing their allocations to the asset class to diversify away form more correlated risks.

Conversely, should investors already have a target ILS allocation, they may need to rebalance their portfolios should ILS now be an outsized slice of their portfolio if other assets have shrunk substantially.

Are ILS structures proving as uncorrelated as expected, and will this have any effect on demand?

For the most part, yes—cat bonds covering elemental perils are seeing low-correlation. Obviously, for structures with risks directly triggered by pandemic exposure, of which there is only the World Bank bond, there is the potential to default.

Some ILS with risks including contingency covers, such as life, mortgage backed securities and so on, may be impacted. For pure natural catastrophe cat bonds, low correlation to the financial markets remains and has been clearly demonstrated.

Cat bonds and collateralised reinsurance exposures are fully collateralised with low risk assets such as cash, US treasuries and/or treasury money market funds with held in highly rated banking institutions.

Further, Reinsurance Trust Agreements or Collateral Trusts allow for substitutions of collateral assets and replacement of Trustee banking institutions.

Are there other implications for ILS that may be less obvious?

There is a risk of claims inflation, loss adjustment expense and fraud if adjusters cannot physically inspect damage due to restricted movement.

Contracting re/insurance balance sheets might necessitate more buying of ILS.

Substantial broader portfolio capital erosion to some existing ILS investors may reduce new capital inflows in the short term. However, stability of returns will make the asset class more attractive.

A new development has led the US House Financial Services Committee to propose the introduction of the Pandemic Risk Insurance Act (PRIA). Driven by the US retail federation, which has been hit so hard by the coronavirus, the bill would provide a reinsurance backstop similar to the 2002 Terrorism Risk Insurance Act (TRIA) introduced following the 9/11 2001 terrorist attacks. This is likely to be an important and prominent discussion going forward.

What are the BSX and ILS Bermuda hearing from clients about this?

For the BSX, COVID-19 has had little impact and ILS deals are still coming to market and are seeking listings. Boards are asking companies to identify exposures in their portfolios.

There is generally a broad understanding that this is an evolving situation and the guidance on any impact to ILS will be preliminary at this stage and subject to change.

What is clear from the impact of the pandemic thus far is the importance of a few key considerations.

First, there is little evidence of contagion in the ILS asset class. Second, COVID-19 has further exposed the global protection gap.

While still early days, if the pandemic takes hold in countries which are ill equipped, both medically and financially, to deal with the fallout, it will expose vulnerabilities in humanitarian efforts and the interconnectedness to the global financial market when it comes to natural disasters.

We expect opportunities for ILS solutions as well as increased acceptance of the asset class due to its proven low-correlation and stable returns. It is perhaps more essential than ever for governments and industry stakeholders to collaborate and look at ILS for stability, mitigating impact to peak natural risk which will assist recovery.

While the future remains uncertain, it’s clear this pandemic is going to reshape the world in many ways. There will undoubtedly be opportunities for the ILS market to adapt to new demands for protection.

Greg Wojciechowski is president and CEO at the Bermuda Stock Exchange. He can be contacted at:  gwojo@bsx.com