ILS market growth should not be at the expense of discipline, S&P warns

Continued and future growth of the insurance-linked securities (ILS), catastrophe bond and alternative reinsurance capital market should not come at the expense of discipline, warns rating agency Standard & Poor’s today.

The rating agency said in a new report that it expects the alternative capital and ILS market will continue to grow, as third-party investors increasingly look to the returns of the reinsurance market as a valued asset class.

Even if not growing at the rapid rate seen in recent years, S&P says that it expects that given the ease and efficiency with which capital can flow into the reinsurance market now and while major catastrophe losses remain absent from the market, it expects ILS market growth will continue.

The alternative capital market will “continue to innovate and push boundaries” in insurance and reinsurance, the rating agency explains. This innovation and breaking down of boundaries will translate into the catastrophe bond market, S&P expects, something the rating agency welcomes but warns should not come at the cost of looser discipline.

“As we welcome this innovation, we continue to caution that any growth should not come at the expense of looser underwriting discipline and less due diligence,” Standard & Poor’s credit analyst Maren Josefs said.

S&P notes that the boundaries between alternative and traditional reinsurance capital are increasingly blurred, as ILS and collateralized players find ways to make their product set more comparable with the traditional reinsurance model.

As a result of the influx of alternative and ILS capital, the reinsurance sector as a whole has adapted by providing more innovative solutions and reduced prices to reinsurance buyers.

The catastrophe bond market is a prime example, where the growing interest from third-party and institutional investors has been driving the market, alongside a desire from buyers to make the cat bond protection more comparable to the rest of their reinsurance tower.

In 2015 S&P has rated $1.3 billion of cat bond issuance, out of the $6 billion plus that Artemis has now recorded this year. However the use of ratings as a part of the market has declined, as ILS markets and buyers have sought to reduce the costs associated with cat bond transactions.

S&P notes that the market has adapted to meet buyers needs, with lower cost capacity in both cat bond and private ILS, or collateralized reinsurance, form. As capital has entered the reinsurance market it created opportunities for buyers, resulting in ILS and alternative markets growing their share of global property catastrophe limit deployed.

S&P expects that the future growth of the cat bond and ILS market will not be linear, with that seen in recent years, but the rating agency says that it believes that the catastrophe bond market will continue to grow by as much as 10% to 20% per year.

Driving this growth, as well as the efforts to keep costs more comparable with traditional covers and the terms on a par, will be investors increasing acceptance of new risks and perils from new regions, S&P notes.

S&P highlights that the expansion of the cat bond market into new perils and regions may be seen on a parametric basis, as the innovation in this area of trigger design and structuring enables new cedents to enter the ILS space, bringing new diversification opportunities to investors.

Overall, S&P expects a scenario of ongoing growth and expansion for ILS, albeit with some caveats and the warning on not letting discipline slide.

“For us, there’s no reason to think this market is going away anytime soon,” S&P states.

S&P’s concerns on discipline largely come down to the expansion of terms and conditions, such as peril definitions, where the rating agency warns that caution must be heeded.

Non-modelled perils are highlighted as one area that discipline should be followed, as these risks (such as meteorite impact) are increasingly being included in cat bond and ILS transactions in order to make the coverage more comparable with traditional reinsurance.

“Under the current market conditions, cedants found it easier to buy protection for these perils,” S&P explains, as the softened market’s heightened levels of competition has resulted in an increased desire to provide a comparable product.

S&P also highlights the widening of the hours clause, such as a recent cat bond that the rating agency states saw a widened event definition jumping the duration to 240 hours from 168, again a common occurrence in a softer reinsurance market.

Longer and shorter duration transactions are also a feature of the soft market, S&P says, such as the recent 6 month hurricane transaction and an attempted 7 year deal earlier this year which failed to make it to completion.

Early termination provision clauses are another sign of the softened, buyers reinsurance market environment, S&P notes, with investors willing to give away more than in previous years. However S&P also notes that the variable reset feature, now commonplace in cat bonds, while an expansion of terms has also greatly benefited buyers with greater flexibility.

S&P highlights the “drive to reduce costs and increase speed of execution to connect risks with appropriate counterparties.” The rating agency poses the question; “Is there a risk of the ILS market overheating and new investors getting burned?”

Liquidity remains a concern for S&P, with the rating agency unsure that much of it will be left after a large catastrophe event occurs. S&P also highlights the trend towards investors and managers providing their own risk modelling and due diligence as a risk, as well as the increasing demand for diversification which could drive prices below their technical levels.

The fact that some low coupon cat bonds, around the 2% mark where many believe the floor has to be, have still successfully come to market is something S&P cautions about. Some of the larger ILS funds decline to invest in these transactions, but for others there is both a need to deploy capital and to diversify.

S&P is questioning whether the risks are worth the returns, at such a low-level, something a number of ILS managers have questioned in the past about these very remote risk transactions.

S&P explains; “Nevertheless, these bonds are being placed successfully. This leads us to conclude that there are investors for whom the diversification benefit is more important than the return they will earn. If these end investors are pension funds, the long-term effect should not be of any concern for the whole market. But if these are opportunistic investors, a portion of this capital could leave the market once yield on other assets increases.”

It is worth pointing out here that portfolio theory, the practice of managing multiple investment assets within a single portfolio, does dictate that at some point diversification should be over-weighted as a benefit.

The benefits of diversifying assets, as part of a larger portfolio can outweigh concerns of lower yield, to a degree. However, there does have to be a limit applied, so S&P is right to caution here.

The trend towards not using a third-party risk modeller is also cited as a potential concern by S&P.

“Sophisticated ILS funds have always been able to perform their own risk analysis. But how are new investors accessing the market?,” the rating agency queries. “If their capital is flowing into the market through the ILS funds, they do not necessarily need in-house modeling. However, some investors might follow the lead of other ILS funds when making investment decisions. In this case, they might be missing certain aspects of the risks they are buying into and might cause market disruptions once they incur losses.”

S&P also notes the important role that a rating can play in structured financial products such as catastrophe bond issuance, noting that this is another area that costs have been cut in recent years.

“Ratings were an additional benefit in the due-diligence process, especially from a pricing and structural standpoint and in the review of the transaction documents to ascertain that these structures adhere to our criteria. Trends to reduce issuance costs and shorten the time to market by placing deals without third-party due diligence are a further indication that the level of scrutiny might be diminishing,” the rating agency continues.

As well as this, for investors and ILS funds who can only allocate capital to rated ILS and cat bond instruments, the options available to them are shrinking. This restricts investment opportunities and also could impact liquidity.

S&P notes that; “What this will mean in practice will only be seen in the aftermath of a big natural catastrophe that affects a number of bonds.”

The issues that S&P raises are all valid. The expansion of terms and definitions is a potential risk, unless managed well by investors and managers. Similarly, the need for third-party due diligence, in the form of risk modelling and ratings, is also valid and has its role especially in the fully securitized cat bond product.

There are investors who want this additional third-party oversight and have mandates that require it. For them and others with these requirements, it would be a shame if the ILS and cat bond market could not meet their investment needs in years to come, although it is likely that it will adapt to do so.

S&P is positive about the future for the catastrophe bond and ILS market though, as long as discipline remains evident. The rating agency sees opportunities to come from government and sovereign catastrophe pools or insurers, citing an expectation that we could see a cat bond from the UK’s Flood Re, the New Zealand government and also from the African Risk Capacity in years to come.

These sovereign type sponsors, as well as increasingly the private insurance and reinsurance market, see the benefits of “transferring the financial risk of natural catastrophes into the capital markets before the event happens.”

So long as ILS and cat bond market participants heed the warning that growth should not be at the expense of discipline, they will likely see plenty of new opportunities to support the world’s risk transfer needs in years to come.