Spooked ILS investors have become wary of which funds they trust
2018 was a year of disasters, from hurricanes to typhoons and then wildfires, with the latter making the headlines as parts of Northern California went up in flames.
With the insured loss estimates continuing to climb, and with liability issues from the fires leading to leading US power company PG&E going to into bankruptcy protection, it’s been a winter of bad news so far for re/insurers.
It came hot on the heels of an equally bad 2017, made far worse for many insurance-linked securities (ILS) funds due to ongoing ‘loss creep’. A number of funds have had to upwardly revise their loss estimates for that year several times, causing much concern to some of their investors.
A flight to quality
This may well have led to another effect. Some investors involved in the ILS sector have paused and rethought things, and a flight to quality on the part of some investors has been triggered.
According to John Warwick, partner and managing director at ILS Capital Management, there is little doubt that, generally, the amount of ILS investment in new and renewal business shrank during the 2019 renewal season.
“This was because with over $200 billion of catastrophe losses in 2017 and 2018 combined, investor confidence was dented,” Warwick says, claiming that this was amplified by certain funds misleading their investors over the losses sustained in 2017.
“This certainly led to a reduction of alternative capital investment in December,” he says. “That being said, however, we are seeing renewed interest from institutional investors for 2019 capital placement, particularly in non-Florida focused sectors of the market.”
Jutta Kath, chief operating officer at Secquaero Advisors, agrees that the ILS market is currently dealing with the investors’ reaction of disappointment. According to Kath, this led for the first time to no new money flowing into the class.
“As a result the ILS market had to exercise what is commonly known as underwriting discipline while available capacity had to be assigned with great care,” she says.
In addition to that, Kath points out, some funds were faced with the prospect of having to serve redemptions in the first quarter of 2019; this also had an effect on the capacity available for the January 2019 renewal. Attempts to put new business into the market via a number of sidecars were met with limited enthusiasm.
As a result of this fall in investor confidence, Warwick feels that the loss activity in 2017 and 2018 and subsequent market reaction have created some very interesting opportunities in niche market sectors. These opportunities are driven by two factors, he says.
“The first is dysfunction in the Lloyds market. Lloyd’s was very late in agreeing syndicates’ business plans coupled with instructions to reduce any and all expense, including reinsurance costs,” he explains.
“The second is the commoditisation of the Florida market, and to some extent the retro market as we saw at January renewals. There was a small uptick in retrocessional pricing but generally reinsurance pricing was ‘risk-adjusted’ flat. These two market sectors have traditionally been considered as the places to ‘get rate’.”
However, Warwick says, the market is not seeing the appropriate risk-adjusted price increases. This will drive investors to seek opportunities outside these primary markets.
Kath identifies continued pressure on capacity in the year ahead for the market, along with increased selectiveness on the part of investors as they seek business that reflects loss experience with rate increases. She also feels that the traditional markets might step in.
Are investors employing selectiveness and caution? According to Warwick, the most telling time to judge investor confidence in 2019 will occur when it comes to ILS support for the Florida renewals in June. The June renewals will also be a test of ILS funds’ ability to exercise underwriting discipline.
“ILS funds are definitely trying to find alternative investments away from standard catastrophe and are also seriously addressing the wording of buffer clauses to facilitate a faster release of ‘trapped’ capital,” he says.
In addition, he says, ILS Capital believes that investors will be more attentive to how funds are structured and for those net asset value (NAV)-based funds, how they mark their positions after a loss.
Kath thinks that ILS investors started becoming cautious over the course of 2018.
“As a result the efforts to explain market developments to investors will have to continue, and this needs to be backed by evidence,” she says.
Kath explains that Secquaero is constantly analysing opportunities for the ILS market to change course and invest in new areas, but adds the caveat that one should not fall into the trap of going for something that is seemingly attractive.
“Whatever the new area, it needs to be transparent with a solid business case—and people also need to remember that just because a risk seeks cover it does not automatically mean it is suitable for the ILS market,” she says.
Warwick feels that the ILS market is ripe for change and will need to evolve to survive years like 2017 and 2018 in the future.
“The opportunities available to ILS funds that can evolve are why we launched our Fund 5 years ago,” he explains. “We believe as an ILS player that we can capture the same opportunities reinsurance companies have enjoyed for years.
“We can build an attractive risk-adjusted portfolio by investing in niche market sectors such as marine and offshore energy, and even select [areas of] US insurance.”
Warwick predicts that by the end of 2019 the ILS space will be leaner, and that with prudent underwriting, kinder contract wordings and the release of unfairly trapped capital, there will be greater investor confidence.
“Investment in ILS funds is a great diversifier for pension funds and high net worth individuals alike, but investors need to be looking for ILS funds that are disciplined in their underwriting process, and diversified outside Florida,” he says.
“By the end of 2019 I hope we will have learned the lessons of 2017 and 2018 and regained investors’ confidence,” Kath concludes.