ILS - Beyond the Boom

ILS explained: The basics of Insurance-Linked Securities

Insurance-Linked Securities are financial instruments which transfer insurance risk from insurance companies to capital markets. They allow insurers to offload some of their risks, especially those related to catastrophic events, to investors. Investors provide capital to Insurers, in return they recieve securities which pay interest funded by that Insurer. The capital is used by the Insurer to cover losses from catastrophic events should they occur. Investors are attracted to these securities because their performance is not correlated with other traditional asset classes, such as stocks and bonds. The typical investors in this sector are investment managers, hedge funds, and in the case of Australia, the superannuation industry. These securities are a novel source of “alternative capital” within the realm of reinsurance protection.

The reinsurance market predominantly (around 75%) focuses on non-life risk areas such as property damage and casualty incidents, with the rest covering life-related risks, including medical, disability, and personal accidents. ILS investments are particularly geared towards non-life risk categories, with an emphasis on property-related risks.

Getting Started: An Investment Roadmap for ILS

Insurance-Linked Securities (ILS) strategies encompass a variety of financial instruments tailored to the reinsurance market. The main strategies are Catastrophe Bonds and Collateralised Reinsurance. Both offering a structured approach to risk management and financial returns.

Catastrophe Bonds have direct linkage to natural disaster risks, providing a mechanism for risk transfer tied to specific weather events. Collateralised Reinsurance, on the other hand, allows for the securitisation of reinsurance agreements, offering a layer of protection against a broader range of risks through fully collateralised positions.

Industry Loss Warranties (ILWs) are also a part of the ILS spectrum, they are a type of reinsurance or derivative contract that provides coverage when losses experienced by an industry exceeds a specified threshold. ILWs are typically harnessed for hedging or arbitrage purposes, focusing on the overall industry loss from specific catastrophic events rather than individual losses.

In recent times, there has been a noticeable shift towards the use of Sidecars and Quota Shares among large investors. These mechanisms provide scalability and direct access to a reinsurer’s balance sheet. This approach allows investors to share in the profits and losses of a reinsurer’s portfolio, thereby aligning interests and arguably distributing risk more effectively.

ILS Market Retrospective: Understanding the Present Through the Past

2022 was a challenging year for ILS, primarily due to the significant impact of Hurricane Ian, which struck Southwest Florida and South Carolina in late September. The devastating hurricane accounted for 161 lives lost and stands as one of the most expensive weather-related disasters in history. In its aftermath, the industry grappled with a capital deficit as reinsurance demands surged. This supply and demand imbalance, combined with economic pressures, such as rising inflation and interest rates, led to a tightening, or “hardening,” of the reinsurance market. This hardening set the stage for a forecast of higher potential returns in 2023. Indeed, 2023 emerged as a landmark year for Catastrophe bonds, which saw unprecedented returns, boosted further by a lull in major catastrophic events.

Source: Bloomberg, 31 December 2023.

Forward Focus: ILS in 2024 and Beyond

A repeat of the magnitude of outperformance seen in 2023 is unlikely. While catastrophe bond spreads remain high relative to history, recent forecasts suggest higher than normal hurricane activity in the second half of 2024. These conflicting factors necessitate a more nuanced perspective on the short-term and medium-term outlook for ILS.

Short-term considerations

We are tempering our view of the Catastrophe Bond market in the short term (3 – 6 months) for the following reasons.

1. Forecasts suggest higher normal hurricane activity in 2H24. The Atlantic Hurricane season is approaching (June to November) and early indications suggest this is going to be a very active season. The European Centre for Medium-Range Forecast (ECMWF) is calling for 23 named storms and 13 hurricanes to form with accumulated cyclone energy at 200% of normal. This forecast matches many others who are forecasting 2024 to be a very active year. The US National Hurricane Centre will begin issuing regular Tropical Weather outlooks from 15 May 2024 which will increase investors focus on this issue. Despite our caution short term, a large hurricane event in the next 3 – 6 month could open an attractive opportunity to increase exposure in the ILS sector.
2. The size of Catastrophe Bond Funds now is a significant risk to liquidity. In 2023, UCITS Catastrophe Bond Funds saw their total assets grow by 25%. By February 2024, the assets under management (AUM) for these funds reached $11.24 billion, with two fund managers each handling over $3 billion. If there is a Hurricane event and UCITS investors look to exit these funds it could cause a significant liquidity event on the market, compounding any existing stress because of the event.
   

   Source: www.Artemis.bm

3.  The Catastrophe Bond market returns have been very strong with the Swiss Re Cat Bond Index up 34% between Sep- 22 to Apr-24. The market has recorded 19 months without a negative return. We do not think this is sustainable.
4. The market is going through a peak of new issuance yet there’s a capital mismatch. The maturity schedule of existing bonds does not pick up until the end of June, which reduces the capital available for reinvestment into new Catastrophe Bonds. There is also not enough capital coming into the market to meet demand imbalance which could see Catastrophe Bond spreads start to widen in the short term

Medium- term considerations

Beyond the short-term, we have a positive view of the Cat Bond Market due to an ongoing hard market which we don’t expect to be resolved within the next 12 – 18 months.

1. Catastrophe bond spreads are still high with the average coupon above 8%. This is a result of higher Catastrophe Bond supply as insurers try to reduce risk via the reinsurance market.
   

   Source: Elementum Advisors, LLC.

    

2. The rate-on-line Index (RoL) is at all-time highs. The RoL (ratio of the insurance premium paid to loss recoverable in reinsurance contracts), is at all-time highs. Indicating that on average people wanting insurance are paying well above the average loss recovered.
   

   Source: www.Artemis.bm

3. Catastrophe Bonds are uncorrelated to traditional markets. With economic conditions changing particularly within fixed income markets, Catastrophe Bond provide an alternative yield without taking on duration risk.
4. 

Risks: The Rewards and Realities of Catastrophe Exposure

Investing in ILS carries inherent risks, primarily from the uncertainty of catastrophic events. While these investments provide compensatory yields for catastrophe exposure, they also carry a low-frequency but high-severity loss potential. The focus for risk management in this space is often on the extremities—the ‘tail risk’ of the investment portfolio. This risk is visually represented by the exceedance probability curve, which portrays the cumulative likelihood of losses surpassing various thresholds.

Source: Leadenhall Capital Partners

The diagram (referenced below) from Leadenhall Capital Partners illustrates the probability distribution of potential losses, emphasising the importance of understanding risk exposure.

Notwithstanding the sophisticated models used to estimate expected losses from natural catastrophes, the unpredictability of these events necessitates prudent capital allocation. JANA recommend investors limit their ILS exposure to a maximum of 5% of their total investment portfolio, or lower for new investors who are still familiarizing themselves with the distinctive risk-return profile of ILS instruments.

Climate change is also a key consideration for investors. The expected effect is that it is likely to increase the average storm intensity and precipitation rates. The impact on insurers is compounded by urban developments in risk prone areas and higher inflation impacting building costs. Consequently, insurance premiums have risen significantly. For insurance the ILS market & Cat bond market, investors are moving risk to remote risk transactions focused on single extreme catastrophes and avoiding the more frequent mid risk perils. To date this has been a successful strategy. Further thoughts on climate change and the ILS market are set out in Appendix 1.

Conclusion

The exceptional returns witnessed in 2023 underscore the potential for ILS to deliver strong performance when conditions align. As we look to the second half of 2024 and beyond, a more nuanced outlook is required, with heightened hurricane activity and liquidity risks presenting short-term challenges – but also potential attractive investment opportunities if bond prices fall.

While the short-term horizon presents possible volatility, the medium-term outlook remains favourable. The sustained hard market characterised by elevated catastrophe bond spreads and high ROL index indicates sustained attractiveness for investors seeking truly uncorrelated returns. In our view, ILS continues to be a valuable addition to an investment portfolio, offering diversification and growth opportunities in an uncertain world.

Appendix 1: ILS and Climate change

Climate change is a key consideration for the insurance sector. Most expect an increase in losses due to more frequent and intense non-peak perils and an increase in reinsurance premiums due to the higher risks.

Global climate models predict hurricanes to cause more intense rainfall causing flooding. A study led by NOAA/GFDL researcher Thomas Knutson² expects a slight decrease in hurricane frequency but an overall increase in average storm intensity, precipitation rates, and the frequency of intense hurricanes. LGT Capital¹ projections on the US property insurance industry suggest that hurricane losses could increase by 10% to 25%in a 4-degree warmer world. 

Global warming climate is a risk, but equally so is urban development and inflation. Other risks include the urban development in high-risk natural catastrophe areas, such as coastal regions, flood plains and wildfire-prone areas. In addition, high inflation impacting construction material prices, labour has significantly increased the replacement value of insured properties.

The insurance sector is adapting to the risk through premium increases. Insurance premiums have increased significantly in the last few years with hurricane prone areas like Florida seeing premiums rise to multiples of the national average. The Rate-on-Line Index which is a measure of the premium paid to the maximum reinsurance limit) reach the highest level in almost 30 years.

The Cat Bond market and investors are demanding less risk. Cat Bonds being issued in the market are being issued with higher attachment points (the loss amount from a catastrophe that needs to be reached before the Cat bond is affected). This important because 2023 was one of the costliest years for natural catastrophes with severe connective storms accounting for a record loss of US $64bn according to Swiss Re. As the losses were largely derived from multiple mid-sized events, attachment points overall were generally not exceeded. Thus, the Cat Bond market was largely unaffected and the Swiss Re Cat Bond Index returned 19.7% in 2023. Cat Bond managers are adjusting portfolio by reducing exposure to high frequency perils and focusing on risk remote transactions concentrated on single extreme catastrophe events.

The European SFDR & EU taxonomy has classified ILS a sustainable investment. ILS investments are seen by EU regulation as supporting economic activity and mitigating and adapting to the impact of climate change. The cost borne by a homeowner to protect against climate change risk assigns a cost to climate change events via insurance premiums thus raising awareness. It also raises the incentive for society to invest in preventive measures such as improved building codes, improving resilience for society against catastrophe risks.

1. JANA’s research has drawn from numerous sources. An article written by LGT Capital Partners on climate change titled “Investing in insurance-linked strategies in a changing climate, Q2 2024” is a particularly useful paper on this topic.
2. Knutson, T., Camargo, S.J., Chan, J.C., Emanuel,K., Ho, C.H., Kossin, J., Mohapatra, M., Satoh,M., Sugi, M., Walsh, K. and Wu, L. Tropical cyclones and climate change assessment: Part II:Projected response to anthropogenic warming. Bulletin of the American Meteorological Society, V7, July 2019.