Moody’s highlights ILS return pressure, negative reinsurance outlook

Rating agency Moody’s Investor Service highlighted that pressure is not just hurting reinsurers, in the current soft reinsurance market environment, but that some insurance-linked securities (ILS) fund managers returns also feel the pain.

A natural consequence of the recent pressure on global reinsurance pricing, particularly property catastrophe, as excess capital and nontraditional capacity converge to force rates down, is that ILS fund managers are finding their returns squeezed as well.

Moody’s highlights this in a report published today which reiterates the rating agencies negative outlook for the global reinsurance sector. In the report, Moody’s says it has no reason to change its outlook currently and lists the main factors which could swing its view in future.

Moody’s analysts now expect the reinsurance price declines will start to decelerate and changes its view for 2015 from a 15% to 20% rate decline to a 10% to 15% rate decline. That’s still significant, but a slower pace than Moody’s thought when it first turned negative on the sector in June.

“Price declines will continue, albeit at a slower rate. We had initially considered a 15%-20% drop in next year’s catastrophe prices a distinct possibility, but such a severe scenario has now become less likely,” commented Kevin Lee, a Moody’s Vice President and the author of the report published today.

One of the reasons that Moody’s feels rate declines are set to begin slowing is that the agency feels that insurance-linked securities (ILS) have less headroom to drive down pricing any further at this time, given that the sector is on course to see one of its least profitable years on record.

Moody’s cites the example of the Eurekahedge ILS Advisers Index, which tracks the returns of 30+ ILS and catastrophe bond funds to give an approximate average return for the sector. Currently the Index is lagging on recent years, as ILS fund returns reflect the much lower returns on recent catastrophe bond transactions.

However, we would add that it is not ILS that is driving pricing down alone. In fact traditional reinsurers have been seen to be leading price declines in many regions, as they aggressively seek to secure premiums for themselves. Also, it is worth noting that while returns have been very low on catastrophe bonds lately, the average expected loss of those transactions is also extremely low, so the lower return is in some cases due to lower risk transactions.

However, the fact cannot be denied, ILS fund returns are going to be lower this year and next, while reinsurance and cat bond pricing remains low, unless ILS managers adapt to the environment and produce innovative new products enabling them to boost their overall fund returns, although perhaps at the expense of some liquidity.

Sound familiar? We wrote earlier today, based on an S&P report, that reinsurers need to adapt and innovate, it seems the same is true of ILS managers. It will be interesting to see whether the nimble approach of efficient capital can outgun the in-depth expertise of the traditional reinsurance model in innovating and adapting their business models to cope with the new, structurally different, reinsurance market that seems to be emerging.

The second potential swing factor is interest rates, as a rise in rates could spur some investors in ILS to look elsewhere, especially if reinsurance rates remain low. Moody’s notes that there are already reports of some capital moving out of ILS, which is (we believe) a natural consequence for some investors who have strict return targets which outweigh a long-term asset class deployment decision. However expectations of any interest rate rises have been lowered lately, which could be positive for ILS, notes Moody’s, so it remains to be seen how it would affect investor allocations.

Moody’s also notes that some investors such as pension funds have been reprioritising ILS from an offensive investment play to a defensive one. This seems a natural evolution for a new asset class though, as investors discover where an asset, which is often difficult to define (eg. fixed income or alternatives), actually sits best within an overall portfolio.

Further disruption could be ahead though, notes Moody’s, with its third swing factor being the knock-on effect and resulting ripples caused by the reinsurance market environment and alternative capital. Lower returns on liquid ILS such as cat bonds could result in more ILS focus on other structures and areas of reinsurance, or lower layers in the reinsurance tower, which could exacerbate competitive pressures for traditional reinsurance players.

At the same time traditional reinsurers are diverting capacity in search of returns themselves, which broadens the softening of the market and can further erode opportunity for the sector stalwarts. Moody’s also believes that the ‘buy versus build’ decision for reinsurers is tipping towards M&A now, but notes that reinsurers will have to offer substantial premiums in order to attract a seller to a deal.

The final swing factor is, of course, mother nature. The occurrence of major catastrophe losses, or a string of attritional catastrophe loss events, is something that it is hard to predict the outcome of. Moody’s says that it increasingly believes that a large U.S. catastrophe event is the most likely factor to determine the long-term penetration rate of alternative capital in reinsurance.

Without a major event though, Moody’s explains, ILS players may have a more difficult time encouraging reinsurance buyers to share more of their programmes with alternative capital while at the same time being unable, or finding it difficult, to command any increase in premiums. That could lead to a slow-down in the growth of alternative capital in the reinsurance market, Moody’s suggests.

So Moody’s along with the other rating agencies remain negative on the reinsurance sector, albeit with slightly lower rate decreases expected in 2015. It is going to be very interesting to see how the rating agencies report on the sector once the all-important January reinsurance renewals are behind us and reinsurers are preparing to report their Q1 2015 results. The outlook has the potential to seem a lot better, or a whole lot worse, depending on the outcome of those renewal negotiations.

It’s refreshing to see it acknowledged that lower returns in reinsurance also hurt ILS managers returns as well, something that is perhaps often overlooked. However, the ability of ILS managers to sustain lower returns depends on their investors, to a degree, which with some ILS investors happy to remain in the space at lower returns with the knowledge that they stand to benefit from any greater shake-up of the market or increase in rates may give ILS managers more staying power (at lower rates) than a traditional player anyway.

As with much of the recent commentary on the reinsurance and ILS market, we are moving into uncharted territory. The market dynamics we are seeing today have not been experienced before, the capital providers, return hurdles and business models are changing, meaning that the outcome is extremely difficult to forecast.

The best we can offer at this time is a suggestion to remain connected and updated, subscribe to our email newsletter or RSS feed is one great way to do that, as the recent reinsurance market dynamics play out.

You can access the full report from Moody’s here (subscription may be required).

Also read our other recent commentary on Moody’s news and reports:

– Catastrophe reinsurance prices could fall below technical hurdles in 2015: Moody’s.

– Moody’s changes reinsurance sector outlook to negative.

– Reinsurance sidecars expected to proliferate and grow: Moody’s.

– Reinsurance downside risks grow, June renewals will test: Moody’s.