What is the Future for the ILS Market?
The cancellation of the Wimbledon tennis tournament at the height of the Covid pandemic could have had major financial consequences for the organisers. However, as became widely known after social distancing restrictions forced the cancellation of the annual event in 2020, the organisation had had the foresight to purchase a certain type of pandemic disaster insurance. Having been triggered by the forced cancellation, Wimbledon received a pay-out of approximately £114 million – a fantastic return on the policy, given that Wimbledon only paid out around £25.5 million in premiums to receive this cover. Predictably, the policy cost spiralled for similar coverage moving forwards, and the decision was taken not to renew the policy.
Whilst not a catastrophe or ‘cat’ bond per se, this type of coverage bears some similarities to the better known cat bond structure. And likewise, the fact that the received pay-out so handsomely exceeded the premium also bears some similarity to the situation in the cat bond market today.
A large-scale survey of ILS managers carried out by the Institute of Insurance Economics at the University of St. Gallen in 2015 confidently predicted that the ILS market would double by 2019. The fact that this did not materialise - over the half decade in question, the market’s CAGR was closer to 33% - therefore represents an open question that advocates of the asset class need to provide an answer to.
In essence, the explanation offered here is that the high concentration of ILS issuance then and now on catastrophe risk has to bear a substantial portion of the blame.
Whilst investor appetite for and interest in cat bonds has fluctuated since their arrival in the early 1990s, it’s fair to say that the last few years have been damaging to the asset class. Initial hopes were that the new structure could simultaneously meet the needs of an insurance market in dire need of more reinsurance and retrocession capacity, and of investors hungry for low volatility returns above the risk-free rate.
From 2017 forward, cat bonds have struggled to generate returns for investors due to the increased frequency and the deepening severity of the natural catastrophe events they offer insurers cover against. 2023 has seen something of a recovery in the cat bond market, although the poor returns of previous years have not yet been expunged from investors’ memories. As can be seen in the chart below detailing the Eurekahedge ILS Advisers Index, total returns for the asset class have stagnated over the past 5 years.
The fact that 2017 represented something of a cliff-edge for the asset class is further reinforced by the chart below sourced from Artemis’s Q4 2021 Catastrophe Bond and ILS Market Report.
Average deal size, which had been consistently above $200 million from 2012 through to 2016, collapsed in 2017 and has struggled to recover since. Meanwhile, the number of completed transactions has risen, potentially symbolising an increased investor appetite for smaller, and therefore less likely to be cat focused, ILS deals.
This article discusses what happened, why, and considers what this means for the asset class going forwards.
Man-made versus natural catastrophes
The unspeakable tragedy of the war in Ukraine and the evolving humanitarian catastrophes in Sudan, Yemen and elsewhere aside, so-called man-made disasters have encouragingly been trending down for some time now. According to research from the CFA, man-made disasters peaked in 2005 at a record high of 250, before declining to just 85 in 2020. Although these numbers are of course only relevant in the context of the value of insured losses, they none-the-less paint a picture of a macroeconomic landscape more and more characterised by decreasing occurrences of man-made disasters.
Meanwhile, natural catastrophe occurrences have spiked from just 50 in 1970 to 189 in 2020. Importantly, the increased frequency has been accompanied by increased severity of events, ultimately leading to rising insured losses. As the chart below produced by Howden illustrates, every year from 2017 forwards has made it into the top 10 largest loss years yet on record.
Exposure to the catastrophe risks which have pushed up losses for insurers and led to cat bonds becoming less attractive has seen seasoned ILS investors reluctant to grow their allocations, and created an effective barrier to entry for new entrants.
Interestingly, despite the scale of disruption and loss to life that Covid caused, it does not yet appear to have delivered insured losses in excess of what have been recorded from nat cat events, or in excess of what could be forecast.
What does the future hold for the ILS asset class?
Today, investors are returning to cat bonds in the hope that the worst is now behind the asset class. Certainly if the past few years of underperformance are excluded, cat bond indices had more than lived up to their reputation for delivering reliable risk-adjusted returns and providing a hedge against broader market volatility.
Specifically, the declines equities suffered in 2008 can be seen in the chart above to have barely registered on the Swiss Re Cat Bond Index.
With allocator interest in the diversifying possibilities of cat bonds rekindling, today some of the most exciting developments within ILS are being driven by the securitisation of non-cat lines of insurance risk such as P&C and life and longevity.
These lines are more attractive to investors eager to tap into the uncorrelated returns cat bonds where and potentially are still capable of delivering, but crucially come without the risk of threat to principal driven by extreme weather events that have since 2017 eroded the ability of cat bonds to deliver the returns that drove their earlier popularity.
ILS beyond cat bonds
The Florida (re)insurance market has long been something of a bellwether for the cat bond market given the states’ combination of exposure to hurricanes and the high value of insured property in the path of named storms.
The climbing cost of claims in the state is shown in the graph below from Howden.
With 2022’s Hurricane Ian seeing paid claims accelerating markedly faster than previous comparable named storms, there are good reasons the anticipated recovery in cat bonds may be slow and more protracted than anticipated.
Non-cat ILS can deliver strong risk-adjusted returns and diversification without the excessive unpredictability of cat bonds.