Relatively strict asset allocation protocols could become a driver for some investors to downsize their allocations to insurance-linked securities (ILS), as broader macro-economic effects and capital market volatility mean some allocations could have to be reduced, to stay within their defined thresholds.
It’s a good point raised by analysts at JMP Securities, who said that on meeting with a number of ILS fund managers in Monte Carlo at the 2023 Reinsurance Rendez-vous event, they came away with the feeling ILS capital is unlikely to grow significantly in the near-term.
ILS capacity remains scarce and raising new funds is challenging right now, with catastrophe bonds proving the most popular segment of ILS that is likely to see incremental inflows from investors.
The inflow tap does not appear likely to be turned on meaningfully, as ILS managers are also increasingly careful at trying to match new capital flows to the opportunity available.
But, after their meetings with ILS managers, the analysts at JMP Securities said, “It is unlikely that capital allocated to the sector will grow in the near term and there is a reasonable likelihood it may shrink, despite 2022 thus far showing strong returns.”
While recent historical performance is a clear issue that has made raising funds in ILS more challenging, the analysts say that, “It appears to us the bigger issue at hand is 2022’s thus-far troublesome performance for bond and equity markets.”
They go on to explain, “A large sum of the funds invested in the ILS sector come from pension funds, which follow pretty strict asset allocation protocols. With a typical allocation being 95% in bonds and equities and 5% in alternatives (where ILS resides).
“The problem is the 95% that is bonds and equities has fallen by 10-20% this year, thereby pushing alternatives/ILS beyond their relative allocation threshold. If a pension fund happens to be in the UK or Europe, the strong dollar can further exacerbate the issue.”
The decline in values of so much of a pension fund portfolio could hurt their ability to even maintain ILS allocations, given the strict targets they are often set.
This despite the market perhaps being as attractive as it has been in years, after the significant re-underwriting, imposition of much tighter terms, conditions and structures, as well as higher reinsurance and ILS pricing.
The analysts concluded, “The most optimistic forecast we heard in our discussions was that “investors might let us keep the earnings”, with others being fairly direct that they are going to have to give funds back to reduce the allocation back to the 5% mark.
“To the extent any new funds enter the sector, cat bonds seem to be the preferred arena, followed by retro, with collateralized reinsurance largely out of favor.”
The analysts also said after their Monte Carlo visit that they anticipate a significant swell in reinsurance demand at the next renewals, with as much as $20 billion in new capacity perhaps being sought.
It may be challenging for the ILS market to become the provider of a significant share of this, despite the clear opportunity to do so now, when traditional reinsurers have been pulling back from catastrophe risks and dealing with their own macro and inflationary problems.
It’s important to also note that those ILS managers with sustainable AuM and decent results in the last year or two stand better positioned than others, while some managers also have investors onboard that have yet to reach their allocation targets and so should enjoy some fresh inflows later this year.