Is ILS facing a tipping point?

The global insurance-linked securities (ILS) market might be on the verge of a tipping point as it threatens to shrink for the first time in years, according to Guy Carpenter’s January 2019 retro report.

The report points out that for the last five years, convergence capital has grown on an annual basis at an average rate of 18 percent, and that as recently as Monte Carlo, Baden-Baden and SIRC in September/October, industry executives were predicting that convergence capital would triple over the next few years to more than $300 billion.

However, by January 1, 2019 the available capacity of the ‘alternative’ reinsurance market seemed to have shrunk, although the market remained active despite a level of diminished capital certainty.

Asked about the causes of the reversal of growth of convergence capacity, James Boyce, CEO of Global Specialties, Guy Carpenter, states that a significant number of funds are likely to post losses for a second year in a row.

“This has an immediate effect on available capacity and could have a longer term effect on the prospects for additional fundraising,” says Boyce.

“Despite the health warning that past performance is no indicator of future returns, a strong track record is important to many investors. 2017 and 2018 followed an improbably benign period for US natural catastrophe losses that flattered returns and disguised the risk that investors were bearing.”

Track record

Boyce points out that the Eurekahedge index tracks the returns of a selection of ILS funds and that the three-year return is negative for the first time since its inception. These results could make fundraising more challenging in 2019—particularly for funds that underperformed this average.

He adds that 2017 results were driven by three ‘CNN events’: hurricanes Harvey, Irma and Maria. These were exactly the kind of modelled, uncorrelated ‘acts of God’ that investors expect to face. The nature of the 2018 losses could be harder for some investors to swallow.

“Much of 2018 performance was driven by factors less accounted for in modelling the risk including loss deterioration from 2017; wildfire liability; and mark-to-market losses due to the supply/demand dynamics of the catastrophe bond secondary market,” Boyce explains.

“For the significant proportion of investors based outside the US, the widening gap between US and European interest rates has also started to drag on returns.”

Communication has also been an issue, Boyce continues, saying that investors have been frustrated by the time that it has taken for accurate loss information to propagate to them from insurers, reinsurers and retrocessionairs.

Trapped collateral

Rising loss estimates from 2017 underscored the importance of adequately reserving for losses which meant that cedants were in no rush to release funds that were supporting 2017 or 2018 events. This trapped collateral created an additional drag on returns. As a result, Boyce says that some investors felt under-educated about this dynamic.

In recent years, several reinsurance funds have increased their use of rated paper. Many cedants prefer rated paper compared to collateralised paper (and the associated documentation) additionally, fronting arrangements often allow funds to add leverage that enhances returns (and exacerbates losses).

Recent M&A activity looks likely to shrink the availability of third-party fronting, although new options continue to emerge, including single investor, rated vehicles.

In addition, Boyce says, outflows themselves can lead to more outflows and that if experienced investors draw back from the sector then new investors will have to explain to their investment committees why they know better. Additionally, all types of investor have some expectation of liquidity. At least one ILS fund restricted redemptions in 2017 and this could increase the likelihood of further redemptions.

The tipping point

According to Boyce, convergence capital is now at a tipping point—finely balanced between investors that are attracted to reinsurance and those that have found more compelling opportunities. In 2019, the appeal of ‘reinsurance as an asset class’ is vulnerable to both further losses and changes in the relative opportunities in other investable asset classes.

He says a number of large, institutional investors and their consultants have continued to reiterate their strategic, long-term commitment to the sector. Other investors will view the hardening market as an opportunity to allocate more capital having scaled back their allocations in previous years. But others will be put off by recent performance and the relative economics of investing in reinsurance.

“By the end of 2018, the S&P 500 had had its worst year since the end of the financial crisis (but still seemed fully valued); corporate bonds posted negative returns; and the US yield curve inverted for the first time in 10 years,” Boyce concludes.

“These macroeconomic stress indicators are compounded by an unusually unpredictable political environment in the US and elsewhere. Now that reinsurance is fully entangled with the global investment market, it is likely to be these factors that will determine the future growth—or shrinkage—of the alternative reinsurance market.”