The insurance-linked securities (ILS) market, for catastrophe bonds, collateralized reinsurance and other insurance-linked investments, is “rapidly approaching an equilibrium” in terms of pricing, supply and demand, according to Validus CEO Ed Noonan.
“We think the ILS market is rapidly approaching an equilibrium point,” Noonan explained during the second-quarter earnings call of Bermuda-based insurance, reinsurance and third-party capital management specialist Validus.
Noonan explained some of the reasons that he and others at Validus feel that the ILS market may be approaching this equilibrium point.
Firstly, Noonan cited the fact that spreads on catastrophe bonds and other ILS have declined as far as they can go, from a return perspective.
“The spread between ILS reinsurance and high-yield bonds is down to 100 basis points,” Noonan continued, referring to the fact that investments in ILS and other reinsurance-linked assets no longer enjoy such a return boost over other asset classes, as a result of the price declines. “And during the second quarter, cat bonds traded at a discount to par value for the first time,” he continued.
Noonan also referenced a specific example of disclipline, as ILS managers stood firm and even gave back some capital in the Florida market, rather than continue to take on risk at ever lower rates.
“We saw good discipline from the largest ILS manager in Florida, a clear sign that investors are reaching their tolerance to declining returns,” Noonan explained.
The emergence of discipline and a slow down in ILS rate declines shows that investors and managers in the space are driven by achieving a reasonable return for the risks they assume, rather than in simply building assets under management and deploying ever more capital into soft markets.
However, Noonan does not believe that this signals the end of growth in the ILS market, saying that he expects to see ongoing inflows of alternative and third-party capital target the reinsurance space, but perhaps at a more moderated pace.
Noonan said; “We don’t see this as the end of capital inflows, but more likely the prelude to a slowing in the broader segment as excess returns disappear.”
Noonan acknowledged that these factors could hurt smaller ILS managers, but he remains convinced that for Validus there is a good opportunity to profit from the reinsurers ILS unit AlphaCat Managers.
“This will create pressure on small or independent managers, but we expect this to remain a very attractive, strategic and financial business segment for us,” he concluded.
In response to a question from an analyst during the call, Noonan explained that Validus are hopeful that the pricing discipline that began to emerge at the mid-year renewals will persist and perhaps become even more apparent by the January 2016 reinsurance renewal.
“We are obviously hopeful that it continues into January 1,” Noonan explained. “The supply – demand balance at mid-year was unique. We’re still doing some exploratory work as to expected supply increases for 1/1.”
“So it’s difficult to give a definitive answer on that at this point,” Noonan continued, however he remains hopeful that the disciplined approach seen at mid-year renewals persists, “But what I can say is that behavior, with respect particularly to the ILS market, was very, very positive.”
Noonan again noted that “some of the leading ILS managers were walking away from business,” as he stressed that pricing has approached the point where the ILS sector no longer finds every deal economically viable.
And then commenting on Validus and AlphaCat’s third-party investor clients, Noonan said; “Our interaction with our customers indicates that they are uncomfortable with the trajectory of rate decreases and the potential returns it offers.”
Noonan expects that as the reinsurance market approaches a floor in pricing, at least for the property catastrophe exposed markets where ILS has a significant share, he expects that to affect the way capital flows into the reinsurance market from investors.
“The dynamic around fund inflows is changing. You can see that manifest itself in bond spreads, you can see it manifest itself in fund inflows and outflows in the marketplace,” he explained.
Noonan’s comments will be encouraging for both traditional reinsurers and ILS players, as they further underscore the feeling that rates are bottoming out. Now, with ILS players seemingly having reached the level where they are not prepared to dilute returns any further, it will be interesting to see how the traditional reinsurance market responds.
Will traditional reinsurers support lower pricing in order to undercut the ILS players that have decided enough is enough? How dangerous could that be over the long-term, once the market reverts back to more normal levels of catastrophes and how will the expanded terms and conditions we’ve seen factor into that?
Competition may drive a desire to keep pricing at or near these lows, despite the fact some are pulling back. That could result in potentially dangerous aggregations of risk at levels that won’t support returns on equity, unless reinsurers also show the same level of discipline seen at ILS fund managers.
For Noonan, the signs are positive though. He explained that “those are all green shoots” and that at Validus they believe “there is a good potential for a leveling of rate moderation into 1/1.” Although he qualified that statement, by saying that Validus is doing some work to analyse potential inflows, for the key January reinsurance renewals, and how that could further impact rates.
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