Investors ILS return expectations may need adjusting to the new normal

by Artemis on March 17, 2016

As the insurance-linked securities (ILS) market continues to mature as an asset class and find its place within the broader financial markets, investors in the sector might need to accept that current rates are perhaps the new norm and adjust their expectations.

In the past, capital markets investors utilised the ILS space and its features to benefit from participation in a diversifying, low correlating asset class that also offered attractive risk-adjusted returns.

However, as the asset class has matured and its investor has become increasingly sophisticated, coupled with a softening re/insurance landscape, returns as attractive as prior years could well be a thing of the past.

“We are in a new balance, alternative risk transfer is here to stay, and I think we also have to adapt our expectations from a risk return perspective,” said Michael Knecht, Partner, at SIGLO Capital Advisors, speaking at the recent ILS & Cat Bonds London 2016 event.

Knecht stressed that it’s unlikely investors in the ILS space will see multiples of five, six, seven, or even as high eight on expected losses as they perhaps were used to maybe five or ten years ago.

“We think that is completely reasonable because what’s happened, is apparently a new asset came to the financial market, if it’s a new asset, which is diversifying, well the natural thing that’s going to happen is re-pricing,” explained Knecht.

It’s a very interesting point and one that further underlines the increased maturity and understanding of the ILS sector’s expanding investor base, and also its stance as a viable and sound asset class within the wider the financial and risk transfer landscape.

As suggested above by Knecht, and also by reinsurance giant Swiss Re recently, the novelty premium within the ILS sector is diminishing, or perhaps has faded entirely.

The novelty premium refers to the extra premium investors might demand in the early stages of ILS market development.

Although for investors in the space it points to lower returns, for the market as a whole this should be viewed as a positive thing, as the natural course for an asset class as it matures within the financial markets is to re-price itself, as noted by Knecht, supporting industry commentary of the sector’s continued maturity.

That being said, returns in the ILS market, including catastrophe bonds, private ILS contracts and so on, are by no means unacceptable, and its low correlating nature and diversification benefits continues to serve increasing investor appetite.

“On a relative attractiveness, I would say after all the costs, we are happy if we get a LIBOR 200. Is that worthwhile for accepting a potential loss of -20 in a severe event every 50, or 70, or every 100 years, yes, we think so,” said Knecht.

Fellow panellists at the event, Alex Neve, Director of Fixed Income at Univest Company and Mike Brooks, Head of Multi-Asset Growth Strategies at Aberdeen Asset Management, also commented on rates in the ILS sector.

Brooks highlighted that he does notice a difference, currently, between the private ILS market and the traditional cat bond space, where the former is writing at higher expected loss levels of say maybe 5%, meaning that a return of between 8%-10% is “certainly plausible.”

However, this simply just isn’t the case in the traditional 144A catastrophe bond market, and expected losses, especially in more recent times, tend to be lower.

“It looks like cat bonds are currently on a net return of cash plus 2.5% net of expected loss, which is kind of OK,” said Brooks, adding that “certainly some of the peak peril risks are still better rewarded, whereas some of the diversifying perils seem to be less so.”

So it boils down to whether as a short-duration asset class, once all the costs are accounted for, if that return is worthwhile, and Neve, like Brooks and Knecht seems to think so.

“It’s still not the best, but it’s still good enough from our perspective I would say,” said Neve.

It’s possible that rates in the ILS space could rise from current levels when the softening reinsurance landscape eventually starts to turn and rates improve there, although it’s been noted numerous times how this market may also have to get used to structurally lower returns than before.

However, it’s unlikely, owing to the diminished novelty premium, increased investor sophistication and overall improved market maturity, that even with a change in the fortunes of the global re/insurance industry returns from a risk/return perspective will reach the heights of years gone by.

But this certainly doesn’t signal a decline in ILS market capacity, activity or interest, as the diversification and low correlating benefits of the asset class are increasingly being realised, with the market poised for further growth into new regions and perils in the coming months.

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