Cat bonds & ILW’s to benefit in any post-Covid-19 ILS market expansion: S&P

More predictable and transparent insurance-linked securities (ILS) structures, offering less ambiguous coverage, may be the immediate winners after the Covid-19 pandemic crisis, with catastrophe bonds and industry loss warranty (ILW) contracts an area set to receive increasing investor focus, according to S&P.

S&P Global Ratings asked in a recent report whether the ILS market could expand following the Covid-19 pandemic, thanks to renewed investor interest and once the broader financial market volatility and uncertainty has declined somewhat.

Catastrophe bonds have once again demonstrated their benefits as a relatively uncorrelated asset that also offers secondary liquidity and so a source of cash in a time of crisis.

At the same time, insurance-linked securities (ILS) funds focused on other structures, such as collateralised reinsurance, industry loss warranty’s (ILW) and sidecars have also significantly outperformed many other alternative asset classes through the pandemic-induced financial market volatility.

Which has helped to raise the profile of ILS investments once again, with investors and consultants extolling the virtues of the lack of correlation associated with reinsurance-linked assets, as well as their defensive qualities and the ability to access cash through the more liquid catastrophe bonds.

But uncertainty does hang over some areas of the ILS fund and investment marketplace, in particular around the potential for there to be some losses from Covid-19, which are largely expected to be due to business interruption claims that find their way through from certain property towers, reinsurance programs and via risk-sharing agreements such as quota shares.

The ILS market went through a period of elevated investor interest after the 2008 global financial crisis and S&P believes elevated interest may be seen again after the pandemic.

The rating agency explained its thinking, “Any boom should be considered in relation to the event’s effect on demand for insurance protection and the supply of capital to invest in insurance risk, rather than to the event itself.

“Most of the expansion in the ILS market following the 2008 financial crisis occurred in the collateral reinsurance space.

“Investors, and specialized ILS funds in particular, started to provide capacity alongside the traditional reinsurance market, for different risk-return strategies.

“By contrast, the cat bond market, where new issuance had reached an annual record of just over $8 billion in 2007, didn’t return to that level again until 2013. Total annual new issuance dropped to roughly $3 billion per year in 2008 and 2009. Only from 2013 onward did new annual new issuance go back up to pre-crisis levels, with significant more growth occurring in 2017 and 2018.”

You can clearly see the decline in cat bond issuance after the financial crisis in our chart that details catastrophe bond and related ILS issuance by year.

But in 2020 things appear to be different, as the catastrophe bond market remains buoyant, having already surpassed some $7.2 billion of issuance as of the end of last week.

“To date, new issuance in 2020 is already double the level back in 2008, and we expect further new issuance to continue as outstanding deals mature,” S&P Global Ratings said.

Catastrophe bond returns have been rising since the pandemic broke out. Partly in reaction to rising reinsurance rates and a realisation that rates were not yet at a level to compensate for losses suffered in recent years.

But this has actually accelerated and one major reason behind that seems to be that the cost-of-capital, in both the insurance and capital markets, has risen significantly due to Covid-19.

All of which is helping to stoke investor interest in the catastrophe bond and ILS asset class.

S&P forecast, “We expect ILS investors to seek higher returns at future renewals, following years of record losses from natural catastrophes, exacerbated by the COVID-19 pandemic. If long-term investors expect to be sufficiently compensated, they are likely to supply alternative capital and remain committed to insurance risk.”

But the inflows we see into ILS may not go immediately to collateralised reinsurance, sidecars and other structures that have less liquidity and are potentially more exposed to any losses from the pandemic that do find their way into the ILS market.

In addition, the potential for more ILS capital to be trapped towards the end of this year (potentially for a prolonged period in some cases) may also push investors to look at more liquid and transferable options for ILS investing, or to reinsurance and retrocession structures that provide a more transparent and understandable trigger mechanism, such as the ILW.

We’re already hearing that some sidecar sponsors are struggling to secure the capital support they had been hoping for.

“This time around, we anticipate the cat bond and industry loss warranty markets will benefit from any ILS market expansion,” S&P explained.

Adding that, “Investments in collateral reinsurance or sidecars are unlikely to expand as they did after the 2008 financial crisis, because they have been affected by liquidity constraints and uncertainty regarding potential losses during the COVID-19 pandemic.”

Of course, there are now plenty of experienced institutional investors backing ILS funds that understand the lock-in and less predictable nature of collateralised reinsurance and retrocession, so we don’t believe the flagship fund managers running those kinds of investment strategies will experience less interest.

But they may experience a slower level of inflows through the coming months, until greater clarity emerges over the potential for collateral to be trapped at year-end, how long that would be for, and over exactly where Covid-19 pandemic losses will land in the insurance, reinsurance and ILS sectors.

For those managing catastrophe bond funds this could be an opportune time to entice new investors who are clearly active in their analysis of the ILS market at this time. We’re hearing from a growing number of new investors to the space and many are looking to access insurance-linked investments in their most liquid form.

Assets that are more predictable, less ambiguous, more transparent and easier to understand are likely to garner attention at this time. Throw in the lack of correlation of catastrophe risk and the more catastrophe bond and ILW focused ILS investment managers could be in for a busy time.