Maturing of the ILS asset class sees ‘novelty premium’ fading: Swiss Re

by Artemis on February 1, 2016

The maturity of the catastrophe bond and insurance-linked securities (ILS) market in recent times, underlined by growing investor understanding and sponsor sophistication, has seen the “novelty premium” diminish, according to reinsurance giant Swiss Re.

The “novelty premium,” as the Switzerland domiciled reinsurance entity calls it, refers to the extra return investors would demand in the early stages of ILS market growth, typically owing to the lack of understanding and relatively new presence of the reinsurance linked asset class as a whole.

But now, as the market has grown in size, and is beginning to access a diversified pool of risks across a growing range of geographies, with a willingness to broaden its reach further, “we’ve seen the ‘novelty premium’ which was required in the early stages of the market fade away as investors have established insurance risk as a staple of their portfolios,” explains Swiss Re.

The rise of alternative reinsurance capital has been a hot industry topic over the last 12-24 months owing to it increasing its share of the overall reinsurance pie, thus impacting rates, and contributing to intense market competition, which in turn resulted in widespread consolidation across the insurance and reinsurance sector.

For some time analysts and executives in the insurance and reinsurance space questioned the permanence of the capital markets investors bolstering the ILS and cat bond space, seeking the returns of an asset class that offers extremely low-correlation to other financial markets.

Underlining this point, Swiss Re explains that since the rise of alternative reinsurance capital and the resultant tightening of spreads in the ILS market, “we’re seeing cat bonds trading around the same levels or tighter than comparably rated high yield (HY) corporate bonds.”

Since mid-year 2014 HY corporate bonds, which are correlated with the wider financial markets, experienced a significant widening trend, while during the same period cat bonds spreads have, for the most part, remained pretty stable, says Swiss Re.

“While the HY market is trading on a shift in risk perception, it appears that the cat bond market is driven by investors’ focus on achieving absolute return levels thus pushing the low yielding risk remote bonds closer to an acceptable yield hurdle.

“This decoupling from the broader market exemplifies investors’ demand for uncorrelated investments as investors retreat from risk in HY but continue to add it in the ILS market,” notes Swiss Re.

Today, however, it seems the majority of noise surrounding ILS and cat bond investors notes the growing sophistication, understanding, and willingness of the institutional investors and sponsors of such transactions to remain in the asset class, and enable ILS capacity to have a meaningful impact on risks outside of the well-modelled, highly competitive business lines, such as U.S. property cat.

Artemis discussed recently how reinsurance broker Guy Carpenter states that capital market investors now provide more than 50% of global catastrophe retrocession capacity.

Furthermore, cat bond lite issuance is climbing each year, and according to the Artemis Deal Directory the outstanding cat bond market reached its highest ever volume at the end of 2015, at $25.960 billion, despite failing to match the record-breaking issuance levels seen in the previous year.

So it’s clear that investors have increased their understanding of the asset class, it’s exposures and benefits, and the sponsors of deals that range from cat bonds, to collateralized reinsurance contracts, retrocessional, to cat bond lites, and so on, have a consistent willingness to enable the transfer for insurance, or reinsurance linked risks to the capital markets.

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