El Niño shifts ILS probabilities in hurricane season, but supply-demand dictates spreads: Solidum

As per Solidum Partners, the onset of an El Niño pattern does not translate into a straightforward rule of thumb for ILS managers and their clients. While a less active hurricane season typically implies downward pressure on nominal spreads, the firm highlights that a broader array of market forces, including capital supply-demand dynamics and total reinsurance capacity, will continue to influence market direction.

In a new report released by the Swiss insurance-linked securities investment manager, which specifically examines how the 2026 Atlantic hurricane season coincides with the ILS market, Solidum outlines that while El Niño is a critical factor, it is only one of the many factors that are important for such a forecast.

“A wide range of information is taken into account when forecasting the course of a hurricane season. In addition to the ENSO regime, the ocean heat content and sea surface temperature in a specific region are particularly significant in the medium term. Shorter-term factors include the position of the Bermuda/Azores High and the phase of the Madden-Julian Oscillation during the peak of the season,” Solidum writes.

“Unfortunately, therefore, even a clear El Niño signal does not allow for a 100% certain prediction of the course of the coming season. However, the probabilities do shift statistically significantly in an El Nino year, and the portfolio management of an ILS or cat bond fund can exploit this shift in probabilities for tactical positioning.”

Yet, the investment manager cautions against oversimplifying how these tactical adjustments play out in the broader market.

“There is no simple rule for what an El Niño situation means for ILS managers and their clients. Given the likelihood of a less active season, one might assume that spreads are more likely to fall. However, there are numerous other influencing factors, such as supply and demand, the total capital of insurance and reinsurance companies, and other variables,” Solidum Partners said.

“It is more important to analyse the spread in relation to the expected risk, measured as the difference between the spread relative to the money market and the expected loss. If spreads fall less sharply than the expected loss, risk-adjusted margins rise, even if they may decline in nominal terms,” the firm continued.

Solidum also observes that much like any other market, pricing serves as a starting point dictated by the market, and how in return, ILS managers must use these figures in order to carefully assess whether investment opportunities are attractive.

The firm goes on to note: “We would also like to mention the year 2024 at this point. In light of the forecasts, we have observed a significant decline in interest in ILS instruments for hurricanes, such as cat bonds, which has led to a widening of spreads.”

As the firm emphasises, this is where an important distinction comes into play, that standard risk models do not respond to El Nino/La Nina inputs. Given this, Solidum stresses that additional and more in-depth analyses must be incorporated into the assessment of ILS investment opportunities.

“Selecting and constructing the portfolio whilst taking El Nino/La Nina into account is a key tactical measure for the ILS manager. Solidum actively utilises this information. A good example is our forecasts for the 2024 and 2025 hurricane seasons, in which we provided an assessment of tactical positioning,” Solidum added.

The investment manager acknowledged that it forecasted a very strong hurricane season for 2024, which subsequently materalised. Consequently, Solidum positioned the portfolio more conservatively, underscoring their belief that navigating such seasons requires looking at the bigger picture.

“Taking all weather data into account is of crucial importance for an ILS manager. This involves not only taking note of and summarising the various weather data, but also having a sound understanding of their respective significance and how they interact. Whilst El Nino and La Niña are important factors, they must be considered in the context of other weather phenomena,” Solidum said.

Adding: “Whilst the impact of El Nino on the hurricane season is undoubtedly significant, a manager must also take into account other potentially costly hazard categories, such as hail and tornadoes in the US. As outlined, it is reasonable to assume that a strong El Nino event will lead to a lower incidence of these events in the US.”

Considering this, Solidum emphasises that the secondary effects on spreads and expected losses need to be thoroughly evaluated. Due to the fact that the markets occasionally respond in a manner that is somewhat detached from underlying climate parameters, astute managers can often find highly lucrative trading opportunities in the secondary market.