Noel Hillmann, Chief Executive Officer, Clear Path Analysis
Adam Beatty, Managing Director, Nephila Advisors UK
Noel Hillmann: Do you expect to see significant price increases and capacity shortages in the Insurance Linked Securities (ILS) sector in the future, perhaps after a major event?
Adam Beatty: The market reaction to the events in 2017 showed that capital can now flow swiftly to any perceived opportunity in this market. These capital flows are quicker and easier than they were in the past. We saw this with the rapid capital flows into the market late 2017, reducing any potential disruption to supply for reinsurance and retrocession business. That dampened the positive pricing effect that might have been there after a major event.
We did see some upward movement in pricing, particularly in January of 2018 but the extent of those price rises was lower than some had been predicting and hoping for.
We would still expect to see upwards pricing movements after large loss events, but perhaps the magnitude of any price rises will be lower than it has been in the past. In 2018, the market had come to some realisation about this new market dynamic. A combination of these factors and the event activity that we had seen in 2018 should be helpful to the pricing environment in 2019.
Noel: Due to the magnitude of the events in the 2017 Atlantic hurricane season, do you feel that the market has seen a predictable inflow of new and re-invested money? Particularly, the increase in allocations from existing allocators in the ILS sector more so than new entrants?
Adam: It was quite a predictable path. We knew from speaking to investors both in the sector and those who were keeping an eye on it, that a lot of them had identified the period after a significant or serious loss event to be a good time to allocate to the sector or increase their existing allocations.
When the 2017 events unfolded it looked to be a trigger for this more opportunistic allocation to occur. This is generally what happened in 2018.
We saw people who might have been on the sidelines who came forward to make an allocation and some of the existing investors in the sector chose that moment to increase their allocation as well, which is entirely logical.
This thesis perhaps played out so efficiently that it dampened the pricing opportunity. Some of the more opportunistic capital flows may not persist in the sector and we may see some of that capital leaving in 2019. It has been an interesting lesson for the market to see the ability of capital to flow in as an opportunity presents itself.
Noel: Do you still see strong investor appetite for ILS after the last 2 years?
Adam: We do and we feel that there is still strong underlying investor appetite despite a couple of challenging years for the sector.
Our investor base, and a lot of the capital in the sector, comes more from institutional investors. A lot of it is pension fund money. These pension funds are making a strategic allocation for the medium to long term. Investors do understand that there are going to be years with negative or lower returns and they remain attracted to earning an uncorrelated positive return over time. This fundamental attraction of the asset class hasn’t changed.
That being said, we would like to see a quieter year in 2019 where we can generate positive returns for investors because despite the rationality of the thesis, investor resolve starts to get tested with three difficult years in a row.
Noel: How can managers differentiate themselves in the current market?
Adam: In more challenging markets, managers can add value in a few ways, but one key aspect is that of access to the risk, the breadth of origination, and variety of risk. The more risk that can be accessed, the better the choice that is available to create attractive, risk adjusted portfolios.
Also, the ability to match that risk with investors capital in an efficient manner is important. Within the ILS sector there can be fees and costs in the distribution chain for catastrophe risk that are beyond the headline management and performance fees that are visible to investors. Minimising these costs to create an efficient, all in one fee for getting that risk from source to investors capital is an important differentiator.
We feel that at Nephila we have a strong origination engine and have built a very efficient infrastructure to get that risk to our capital.
Another important point is that in years where we see events happening, like in 2017/18, it allows managers to differentiate themselves through their communication with investors around the events.
We know and understand that investors want information on the likely impact of the events to the funds they’re invested in and would like it as soon as possible both during and after an event occurs. It takes some time for ultimate losses to develop in the insurance and reinsurance markets. Providing helpful data and estimates of ultimate losses in a timely manner can assist investors in understanding the business as well as the likely outcome for the fund. This is an area that we have devoted attention to in order to provide helpful feedback to investors swiftly after an event.
Noel: Are investors concerned about the impact of climate change on the sector’s risk profile?
Adam: This is a question that we get asked more frequently from investors than in the past. Clearly the impact of climate change is an issue for all businesses and governments to consider. Investors are increasingly keen to understand the impact of climate change on their overall portfolios and to think about how they can invest in a way that is responsible and encourages sustainability.
ESG motivated investment is increasing rapidly and is something that we are hearing more about from our investors.
In the catastrophe risk sector, the immediate concern for investors is to understand whether climate change is shifting the risks that we face now. In particular, we get asked a lot about whether hurricanes are occurring more frequently and with more intensity, as this is quite a widely held perception and is certainly fuelled by most media coverage of hurricane events. We have shared quite a bit of research on this topic with investors and in fact there is not yet a discernible longer-term trend of more frequent and intense hurricanes.
Over the last 50 years there has been, on average, one major hurricane, that is a category three and above on the Saffir-Simpson scale, that has made landfall in the US every two years. We have had one in 2018 and two in 2017 which is a busy couple of years. Before 2017 we had a 12 year stretch of no major hurricanes making US landfall at all.
Another point that we make is that most of our assets are invested in one-year trades and the underlying catastrophe modelling and risk analysis can be updated over time for any changes in the view of risk.
In recent decades though, we have seen increasing losses to hurricane events. That has actually been driven more by there being greater exposed property values rather than actual changes in the hurricane hazard itself. To simplify this, there are more buildings that are being built in the path of hurricanes that have the potential to be damaged rather than the hurricanes being particularly different.
We do feel that climate change is something that we can monitor and factor into our investment process over the longer term. It could also be a driver of increased demand for protection from rare, high severity events. Our investors can earn a diversifying return for providing the re-build capital that makes economies more resilient to these large natural catastrophe events. We feel that this can be an attractive fit with responsible investment and ESG strategies.
Noel: In respect to climate change and new ILS and ESG related opportunities, there are new insurance products that have been created to help businesses offset the risks climate change poses. Areas, for example, such as insurance of renewable infrastructure. Do you feel that these new industries will open exciting new insurable perils that allocators can include in their ESG bucket?
Adam: Yes, absolutely and we are starting to see that happen. Our Nephila Climate (“NCx”) business, which invests in a series of weather and climate related risks, is starting to see more opportunities to provide hedges to renewable energy investment projects, whether this be wind or solar farms. These facilities usually need to raise quite significant debt finance as part of the original investment. They therefore face the significant risk that the wind won’t blow at their chosen location or that the sun won’t shine on their particular solar farm, which undermines the business case for the bank to provide a loan.
Our colleagues in NCx have been able to structure a hedging product to facilitate the management of this risk, and hence the financing of those loans. We see this business growing more as the world shifts further towards renewable energy and away from fossil fuels.
This is an exciting part of the business that has clearly got some ESG benefits for investors who are particularly interested in making these sorts of allocations.
Noel: Thank you for sharing your thoughts on this topic.
Adam Beatty was sharing his views following Nephila Advisors contribution to the seventh annual Insurance Linked Securities for Institutional Investors report, released in June 2018. The 2019 edition of the publication will be released in June 2019.