Investor interest builds after Covid-19 demonstrates ILS value as an asset class

One of the key takeaways of the third of The ReInsurer’s virtual panel discussions was the returning optimism among ILS investors.

Investor confidence is now returning in the ILS space after concerns over the impact of Covid-19 prompted concerns at the end of Q1. Judy Klugman, managing director at Swiss Re Capital Markets, told the debate Covid-19 had initially had a significant impact on the ILS market, with spreads widening by 20 to 30 percent before the market began to stabilise from April onwards.

“The fear of redemption that many investors had did not materialise. We now see capacity flowing back into the market. We have a healthy equilibrium and a very healthy market going forward.”

Stephan Ruoff, who this month succeeded Dirk Lohmann as head of Schroder Secquaero, said the ILS market held up strongly in Q2 with a “lot of new issuance coming through”.

“In the cat bond space, we can be proud to be part of an industry that has cruised through the crisis.

“For collateralised reinsurance, there is much more uncertainty, with valuation questions now being discussed on the back of another year of trapped collateral.”

Paul Schultz, CEO at Aon Securities, said the start of the year has seen strong momentum with bonds showing strong resilience compared with other asset classes.

Michael Millette, founder and managing partner at Hudson Structured Capital Management, said the key impacts from Covid-19 had been in collateralised reinsurance, particularly for retro coverage where all perils coverage has been offered.

“Collateralised retro is a $20bn market and there is some investor fatigue following a fourth year of losses which are outside of shake and wind. We have had flood, fire, post-event loss creep and now BI.

This will drive revisions to terms and conditions in collateralised retro.”

Philipp Kusche, global head of ILS and capital solutions at TigerRisk Capital Markets, said Covid-19’s impact on ILS varied across products with the most significant impact being collateral trapping on the retro side.

While ILS as an asset class remains in a strong position, Kusche said some of the challenges posed by Covid-19 had limited opportunities to conduct on site due diligence and face-toface meetings, which had in turn slowed down some fundraising discussions.

Investor interest builds Millette said the overall pace of fundraising has slowed over the past three years but said investors were “watching closely and starting to move” following ILS performance during the Covid-19 crisis.

“The reason ILS took off as an asset class was because of its reasonable performance in the financial crisis. The sector seems broadly resilient to Covid-19 – there is some watchful encouragement from investors, and they are starting to move,” he said.

“But some are still wary because of the sequence of events in 2017, 2018 and 2019 when a lot of money came into the sector but got hit by mid-sized events.”

Ruoff said the European market was becoming more active, with more interest in cat bond issuance emerging over the past 18 months.

“This points towards the European market moving towards hardening and large cedants in Europe trying to diversify their panels,” he said. “On the investor side, we have a strong pipeline for investors who are looking at cat bond products, attracted by the liquidity of the asset class, high yields and wording clarity. They can invest in a class which has already proved its value.”

In contrast, Ruoff said there has been investor frustration around collateralised reinsurance.

“We are still having conversations with investors to address these issues. There are questions around valuation and unmodelled perils still to be answered,” he said.

Strong cat bond pipeline

Catastrophe bonds are seeing a surge in investor interest in the aftermath of Covid-19, with issuance expected to grow next year. Millette said cat bonds were experiencing rising interest in part due to their performance during the ongoing pandemic.

“The bond space tends to be top layers and it tends to be named peril, so cat bonds were relatively less impacted by the potential for loss arising from coronavirus,” he said.

“The main impacts have been in collateralised reinsurance and especially collateralised retro, where you have all perils coverage.”

Kusche said this dynamic had increased the attractiveness of the cat bond market to investors.

“Cat bonds have seen fewer loss impacts in the last few years and are seen as more robust with more liquidity than other ILS classes. Cat bonds is where we are seeing quite substantial interest from investors,” he said.

Schultz said the pipeline for cat bonds for Q4 and beyond “looks extraordinarily strong”.

“We expect issuance to continue to grow into 2021. The relevance of the cat bond product is probably higher than some of the other products that comprise the ILS portfolio,” he said. “Cat bonds have grown 5 or 6 points as a percentage of the overall ILS market over the last couple of years and we expect that to continue into 2021 as both cedants and investors gravitate more towards bond products.”

Wildfire concerns continue

ILS investor caution over wildfire risks is continuing to mount amid concerns over modelling capabilities and pricing adequacy, the panelists warned.

This year has seen record acreage burn in California, which followed unprecedented insured wildfire losses of around $25bn across 2017 and 2018.

In the retro market, where alternative capital now plays a dominant role, there has been a push back on wildfire exposures. Schultz said wildfire is more challenging than other perils in the market.

“Among investors, there is a lack of confidence in the level of understanding of the peril. It’s a question of how investors become comfortable that existing models are adequate, and that will take some time to play out,” he said.

The high levels of loss activity experienced in 2017 and 2018 have seen retro cover for wildfire risks, which typically renews in January and June, shift from being structured on an aggregate basis to an occurrence basis in a bid to better manage exposures.

This has in turn driven up reinsurance pricing for wildfire exposures.

Ruoff said it was concerning that California has already seen record acreage burn in 2020 when the wildfire season technically does not even begin until later in the year.

“We have positioned our portfolios away from wildfire – we do not believe you can consistently model wildfires for investors,” he said.

Millette told the virtual panel discussion the ongoing wildfires were the latest signal of a changing climate.

“Since 2017, we have seen a lot of fingerprints of climate change with a net shift from wind and shake to water and fire,” he said. “Hurricane Sally is essentially a water event. We have a fire event going on in California and up through the Pacific northwest. And we need to regear some of the models to deal with that.”

Kusche said investors were focused on responding to the wildfire peril.

A lot of work has been done since 2017 to improve modelling and awareness through the ILS sector, he said.

“But there remains a pricing question around what is perceived to be adequate for something that is clearly an increased risk,” he said.

Klugman cautioned however that there is a difference between an active wildfire season and losses that actually eat into towers.

“My understanding right now around wildfire is that there has been around $1bn of losses, so in terms of where we are right now, that should not have an impact on our asset class.”

Retro hardening at 1.1

Ruoff said the retro market had seen significant hardening at the 1 January 2020 renewal, with additional and even more significant hardening expected at 1.1 2021.

“We estimate trapped collateral totals around 30 percent of the $20bn capital in this space,” Ruoff said. “The question is then what will replace that lack of capacity. Any new capacity that comes in will be for better defined structures than the aggregate structures it has replaced”.

Ruoff said he did not expect that capacity gap to be easily filled without structural changes, even if price increases are in place.

“Retro has always moved more quickly than other areas of risk transfer, with a lot of money made and lost in this space.

“Capital has always come back if the threshold of pricing goes beyond a certain point. If retro is underwritten properly, we see investors coming in.”

Kusche said the retro market was seeing the most dislocation of all ILS sectors. “That dislocation could last for 12 or 18 months or more – it is hard to predict future events. Covid-19 is not over yet. While equity markets have recovered significantly, it is too soon to say there won’t be any volatility.”

“The typical aggregate retro contracts of the past have seen a number of shortfalls in terms of collateral trapping and other concerns,” he said.

Klugman said she expected a shift towards structures such as cat bonds in Q4 and beyond.

“Our expectation is that more of those will come to market in Q4. It may be seen as a small price to pay to take on basis risk rather than looking for cover on an indemnity basis where capacity isn’t there.”

“Retro buyers may become comfortable with that basis risk if it’s a cheaper alternative for them and they can assess their portfolio and measure it against a PCS index.”

Schultz said it was likely retro will see some fundamental changes, starting with wordings and terms and conditions.

“If you go back in time, retro was all written through rated balance sheets before ILS broke in. It is possible we will see a shift back to cover being written through rated balance sheets.

“There are a lot of moving pieces and the water could be pretty choppy here for a while. This is a market set for a lot of changes, in 2020 and beyond.”

Watch The ReInsurer’s third virtual debate in full here.