By Dirk Lohmann, Chief Executive Officer, Secquaero Advisors and Noel Hillmann, Chief Executive Officer, Clear Path Analysis, Publisher of the annual “Insurance Linked Securities for Institutional Investors” report.
Dirk Lohmann - Perspectives of an ILS manager
Coming into the renewal season in mid-October there was a lot of uncertainty as to the potential impact of third quarter events on the reinsurance market and the alternative reinsurance market engaged in collateralized reinsurance transactions. The general consensus at the time seemed to be that the collateralized reinsurance market, as the dominant provider of retrocessional capacity to the reinsurance market, would face large losses or, at worst, a significant proportion of the collateral posted to secure obligations would be trapped and unavailable for renewal on January 1. The overall magnitude of estimated insured losses (ranging at that time between $100 and $190 billion) seemed to suggest that a major price correction was surely on its way. Ultimately, the renewal was late in coming, with many contracts only receiving firm orders in the week before Christmas or in the last days of the old year. While late, the resulting renewal was orderly with little distressed buying and the rate increases achieved were lower than many market commentators and peers had predicted. What happened?
From our perspective, there were three key drivers behind these developments:
- First, while the quantum of losses insured was large, frequency proved to be more of an issue than severity. This led to higher retained losses in the insurance sector and reduced the impact on reinsurers. Those who purchased low attaching or aggregate covers made recoveries, but much of the loss remained within the insurance industry’s retention. For most reinsurers the 2017 losses were an earnings event and not a capital event, overall capital in the traditional reinsurance sector was largely unchanged coming into 2018.
- 2017 was a capital event for the ILS sector with losses estimated at around $12 to 15 billion, however, the ILS market for collateralized reinsurance and retrocession was very successful in raising additional funds to close the gaps created by the losses of the 3rd and 4th Quarter. So much so that the total capacity within the alternative reinsurance market was larger after the events than before. It would appear that initial estimates of impairment or trapped collateral proved to be pessimistic and may have resulted in more capital being raised than perhaps needed.
- The relative strong performance of the Catastrophe Bond market, which only saw a drawdown of approximately 5% of its notional, encouraged many to allocate more to the liquid segment of the alternative reinsurance market. At the same time, issuance during the 4th quarter was somewhat lower than in previous years resulting in an overhang in demand for bonds.
During late October and November when the renewal pricing process normally begins, there were very few price points available to guide the market in terms of where rates should go. The issuance of Cat bonds by XL Capital, USAA and the California Earthquake Authority in early November gave some guidance which ultimately proved to be a good indicator of where traditional placements would end. Tranches at lower attachment points and with higher expected loss saw increases in the 10 to 15% range, while more remote loss free tranches and those offering diversification away from US Hurricane (California earthquake) saw more modest increases or event flat prices when compared to earlier comparable transactions. These developments tracked well with the observed price increases on traditional and collateralized reinsurance placements that generally ranged between +10 to 25% on loss impacted covers and flat to + 7.5 / 10% on loss free covers.
The events of 2017 and the ILS market’s ability to respond positively demonstrated the resilience and strategic importance of this sector to the overall reinsurance marketplace. With few exceptions, the performance of ILS Funds was within the ranges advised to investors for losses of the magnitude experienced in 2017. This gave investors the confidence to rebalance or increase their allocation to the sector post event.
Noel Hillmann – How 2017 confirmed ILS as a mainstream alternative asset class
As observers on the Insurance Linked Securities market and trackers of asset flows around the alternative investments sector, we found the lack of major weather events pre-2017 to have a surprising impact on asset owners: they didn’t budge in their interest for allocating to Insurance Linked Securities (ILS), despite the depressed returns.
Whilst fewer new pension plans and foundations were talking about allocating to ILS, few we spoke to said they were likely to move away. Even between September to December 2016, when we were polling asset owners ahead of release of our annual Insurance Linked Securities – Asset Owner Insights survey, we found 32% of asset owners with existing exposure to ILS risk were intending to allocate more than 3% over the following 12 months. Almost two-thirds believed in having an allocation of over 1%, a still healthy level for an asset class that’s only been a common point of discussion amongst asset owners and their consultants in the past five to ten years.
As we moved into hurricane season of late 2017, the concern that the prolonged period without a major event might dampen investor interest, was widely felt. However, hurricanes Irma, Jose, Maria and overall the fifth most active hurricane season since records began in 1851, evaporated any possibility 2017 would follow the few years before.
In our survey of asset owners that followed from September through to December 2017, we found (to our pleasant surprise) that 7% of asset owners who hadn’t allocated before were intending to start doing so with a further 7% expecting to increase their allocations to ILS above the 5% of total assets held in the next 12 months.
Other key results included:
- Almost half (46.94%) of our survey respondents have in excess of 31% of their Assets under Management (AuM) in alternative investments, compared to 18.6% in 2017. It suggests there is a greater appetite for risk in the market, as investors with allocations of between 16 and 30% would appear to have largely increased their allocation to ILS.
- Growing confidence in allocating to ILS is supported by the fact that no investor would switch their allocation based simply on the fact their consultant doesn’t offer a recommendation. In 2017, this figure was almost 1/3 (30%).
- Evidence that investors maintain a significant degree of caution in how they expose themselves to ILS risk, is apparent in the increased diversification of perils in the ILS allocations of the respondents. Allocation to natural catastrophe risk is down to 43.88% from 50%, but this is not unsurprising given the number of natural disasters that occurred in 2017.
Our survey concluded that ILS as an asset class has now arrived as a mainstream asset class, in the same vein as private equity, hedge funds and Commodity Trading Advisors (CTAs), able to ride the highs and lows with a core group of investors maintaining their allocations. The next era starts: how wide can ILS coverage go?