Demand for fully collateralised cover may rise on pandemic risk awareness

There is a chance that reinsurance and retrocession buyers begin to favour fully collateralised protection more highly again, as they become increasingly aware that there are financial and economic risks which of a scale that can threaten traditional re/insurer solvency.

The insurance-linked securities (ILS) market was a fully collateralised source of reinsurance and retrocessional protection for many years and one of the reasons ILS and instruments such as catastrophe bonds came about in the first place, was a realisation that the there are exposures for which it is preferable to diversify the risk outside of traditional re/insurance.

ILS and catastrophe bonds come with practically zero counterparty credit risk as a result of their fully collateralised nature, making them particularly attractive in times of stress or when it suddenly seems like everything that has a solvency link to the financial markets and economy could be at-risk when the proverbial hits the fan.

The fully collateralised nature of many ILS structures, be that catastrophe bonds, collateralised reinsurance from an ILS fund, sidecars, or industry-loss warranty’s (ILW’s) comes with a promise to pay backed up by collateral held in the most stable of assets, such as treasuries.

As a result, the collateralisation is close to cash, meaning the payout amount for a claim is held in trust, remote from both protection buyer and seller, so the money is there in the time of need and there is a very low probability it would ever be impacted by major world events.

In the traditional reinsurance and retro market though, major events that move worldwide markets, such as this coronavirus pandemic, have an effect of reducing solvency of traditional re/insurers, perhaps heightening the risk they one day may not be able to pay.

It can also weaken their balance-sheets, effectively reducing their available capacity to deploy as well in extreme cases. All of which makes the fully collateralised reinsurance and retrocession from the ILS market seem particularly attractive once again.

Broker Aon, in a recent client update seen by Artemis, highlighted the potential for coverage from the ILS market to become more in demand because of the current crisis.

“Catastrophe bond investors fully collateralize the limits they write, and that collateral is invested in some of the safest assets such as U.S. treasuries, limiting the impact from financial market volatility,” Aon explained.

Adding that, “The COVID-19 outbreak is likely to increase the demand for this cover as potential sponsors become more conscious of global pandemic economic risk and select markets look to be opportunistic in providing cover.”

At this time, as we’ve explained, the ILS market is continuing to operate as normal, with the main impacts on it being an impending potential loss from the World Bank’s pandemic catastrophe bonds and swaps, a sell-off of cat bonds by more generalist investors that have been largely purchased by specialists (although this has slowed somewhat) that does have some implications for the market going forwards, and also some redemption requests from investors looking to ILS funds as a potential source of cash in a stressful time.

Aon explained that while, “The COVID-19 outbreak has disrupted industry segments within the global economy and pushed nations to the brink of a recession.”

The impact to ILS has so far been, “Relatively muted given the limited cover placed for pandemic catastrophe events and the asset class’ fundamentals around diversification for investors.”

Those asset class fundamentals of insurance-linked securities (ILS) persist, of course. They do not go away even during this time of stress.

As an alternative asset class, that exhibits defensive qualities for investors in being relatively uncorrelated to the broader financial markets in times of stress, ILS, catastrophe bonds and direct investments in reinsurance related risks offer, ILS is a relatively stable place to allocate in times like these.

Which will help to sustain investor interest at a time when other assets are suffering, helping to keep the flow of collateralised reinsurance moving and meaning the market can respond to any increase in demand.