Recent loss events around the world have highlighted the fact that as ILS funds and managers increasingly deploy capital through collateralised reinsurance and private deals, they are becoming more specialist and diversified but also more exposed to a range of loss events.
This is ultimately a positive for the insurance-linked securities (ILS) and alternative reinsurance capital space, and its investors, as the additional choice, diversification and range of risks or perils covered can enhance returns and provide greater options to the investor base.
But it does mean that some ILS funds and their managers are becoming exposed to a broader range of events, new risks from specialty lines of reinsurance business and exposure to attritional catastrophe or weather events seems to be growing too.
As ILS fund managers become increasingly specialised, sophisticated and adept at accessing new reinsurance programs and risks through collateralised reinsurance contracts, the breadth of exposures in ILS expands.
This enhances the returns possible in the ILS space, we see many ILS managers adding new risks to portfolios to offset declining rates in more established lines and brings much greater diversification into ILS fund portfolios.
It also allows ILS managers to compete more broadly on the global reinsurance stage, becoming trusted risk capital partners across more than just catastrophe lines of business, which in turn can increase and enhance the ILS managers access to those more core risks as well.
But it does mean that investors will have to increasingly get used to hearing about more frequent loss events that impact, or potentially impact, the funds they invest in.
This year has been a prime example, with a number of loss events to which some ILS sector exposure has been reported, which in previous years may not have been the case.
So far this year catastrophe and man-made loss events such as the severe storms in Sydney and New South Wales, Australia, the Tianjin port explosions and the Chile earthquake, have all required some action from a number of ILS fund managers.
Not all the events will result in a loss, but ILS fund managers have been reserving against them, or reporting potential (albeit minor) impacts to fund NAV from these events.
Just in September wildfires in California swept through the state resulting in an expectation of insured losses of around $1.15 billion. With the wildfire season’s loss tally now risen above that level, it’s understood that at least one ILS manager had a small, perhaps even negligible, exposure to these events and reported as such.
Aviation is one of the specialty reinsurance classes where there is the potential for ILS fund exposure now, with a number of managers adding this class to their portfolios. Last year’s heavy aviation war losses resulted in some work for ILS managers, although we believe only small losses if any, but again this comes to light with the expectation that the recent crash in Egypt looks to be terrorist related, according to reports, and so could hit the aviation war insurers.
Similarly the energy reinsurance sector is a growing area where ILS managers play, with both energy and marine lines among the specialty areas of the business where ILS fund managers feel risks are well modelled and catastrophic in nature.
Energy physical damage losses in 2015 have also been high to date, leaving the potential for some level of exposure. Whether that translates into any ILS losses remains to be seen, but again it’s an example of an area where ILS investors may have to get used to seeing more regular loss estimates.
The growth of collateralised reinsurance and private ILS transactions not only adds exposure to new lines of business and risks, it also can have the effect of bringing the protection further down the tower, resulting in exposure to more frequency and aggregation of catastrophe risks.
As collateralised reinsurance deals have become increasingly customised, as ILS markets look to provide what cedents want in the way of coverage or find that they need to match the traditional markets offering, it can result in greater exposure, while generating greater return for investors as well.
The market dynamic of reduced pricing and high competition in reinsurance has also helped to push this trend, with more coverage for lower return, as well as the expansion of terms, all likely to result in more frequent losses, for some ILS managers, in the future.
Of course this is all a sign of the increasing sophistication of the ILS market, with managers having staffed up significantly in areas such as risk modelling, actuarial and of course underwriting in recent years. No longer is it as simple as allocating capital to a number of cat bond issues throughout the year.
The technical expertise in ILS has risen significantly over the last five years and as ILS capital becomes a growing piece of global reinsurance capacity we should naturally expect the occurrence of losses to become more frequent.
Still, some ILS managers and funds will remain focused on the high severity, low frequency of major global natural catastrophe events. While others will increasingly look to expand, add specialist classes, move down the protection tower and add frequency risk.
As strategies diverge and the market becomes increasingly sophisticated we will see more frequent losses, or at least more frequent reporting of potential losses (the attachment levels will still remain high). As long as this expansion goes hand-in-hand with hiring of specific expertise to manage it, the chances of over exposure should be minimal.
For large institutional investors looking to access the returns of pure insurance and reinsurance business the trend is a promising one. In years to come the ability to invest in a range of ILS funds and manager strategies, across risks, perils, severity, frequency, levels of attachment and types of structure, will all provide more choice and the potential for diversification within allocations. That can only be a good thing in the long run.
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