Equity investors focused on the reinsurance sector question whether insurance-linked securities (ILS) deliver cost-of-capital benefits, while also finding it hard to consider reinsurers an ESG appropriate investment, Andrew Ritchie, Partner, Insurance Research at Autonomous Research LLP said today.
Ritchie was participating in Munich Re’s 13th annual insurance-linked securities (ILS) roundtable, which was held virtually again this year, as the Monte Carlo Rendezvous event was cancelled due to ongoing pandemic challenges.
Ritchie, who is a highly-respected analyst in the insurance and reinsurance space, provided some fascinating and challenging views, as he explained how his clients, the major equity investors in re/insurers, view the use of ILS capital in the marketplace.
One interesting point Ritchie highlighted early on in the discussion, is that catastrophe bond expected returns are largely below the implied cost-of-equity of the major reinsurance players.
“My observation of the last twelve months is a dramatic spread between expected returns between parts of the ILS market, particularly cat bonds and the expected returns, or the cost-of-equity that the market is demanding of listed reinsurers.
“By my calculations, since 2019, I think new issue cat bond yields on average are down 200 basis points. The implied cost-of-equity, judging from the price to book or the P-E of listed reinsurers over the same period, is up about 200 basis points. Some of that divergence is a wider phenomena across equity and debt markets, but is also a view on frequency and loss frequency, and to what degree can the industry, the reinsurance industry, get on top of so called secondary perils.
“Those clearly impacting lower parts of the capital structure, the listed reinsurers, whereas the cat bond market is sailing on regardless, given, they are not affected by returns at that lower frequency.
But I just, there’s a disconnect, which I’m not sure how it works out, between the implied cost-of-equity of the listed reinsurance sector and the apparently very low cat bond new issue yields
“From data I have, this is the first time now, where the dividend yield on reinsurers is now higher than the average cat bond new issue yield. It’s the first time this has happened that I can now observe.”
This suggests catastrophe bond backed reinsurance and retrocession is becoming an increasingly attractive capital source for reinsurers and insurers, although it also suggests the ILS industry needs to be certain it is covering its own cost-of-capital, loss costs, expenses and margins with these lower yields.
But it does provide further anecdotal evidence that the cost-of ILS capital is less than that of some traditional reinsurance firms.
Ritchie went on to explain that investors are frustrated with the traditional reinsurance industry at this time.
“For the listed reinsurers, the level of investor frustration with the industry is very high.
“There is a view that, there’s a lot of talk about better pricing, better discipline, but unfortunately, those normalised earnings, never happened and it looks like 2021 will be the fifth year of above average losses and investors are doing a serious rethink, as to what degree reinsurers are really pricing for some of those frequency issues,” he said
Adding that, “There’s been a lot of talk about moving up the risk curve, of moving away from volatility, curtailing capacity to aggregate covers. But there’s not a lot of evidence of it yet, in delivery of improved returns.
“The listed reinsurance industry needs to deliver several years of decent returns, and show that they’re really particularly getting ahead of this, this frequency issue.”
Ritchie then turned to how his investor clients view reinsurers’ use of alternative capital and ILS vehicles, in particular referring to managed capital vehicles such as reinsurance sidecars.
While sidecars provide retrocessional capacity, our readers will of course be aware that they also provide access to capital that is supposed to be at a lower-cost, or more efficient, in the way the investors seek direct returns from underwriting business.
But, according to Ritchie, the strategy is not impressing the equity investors in reinsurers. In fact it leads to some frustration, in many cases.
“From the wider capital markets perspective, I think there’s only a very small number, maybe only one, listed reinsurer where if you ask investors about their use of sidecars as a risk offset strategy, there’s only one probably that has managed to lower its overall cost-of-capital by effective use of a sidecar,” Ritchie said.
Further explaining that, “I’d say one of the frustrations of equity investors in reinsurers, is that there’s not many examples of that successful use of a sidecar, lowering the actual cost-of-capital. There’s been a handful, as I said, I think really only one.”
Part of the problem here is that reinsurance companies are not transparent in how they use alternative capital or in the benefits that provides to their business models, if any.
It’s extremely hard to see whether a reinsurer is really benefiting from its use of ILS capital, except for in a handful of cases.
This is leading to concerns among equity investors it seems, so perhaps reinsurers would be well-advised to consider how they can expose more information on the benefits to their underwriting strategies, cost-of-capital and ultimately profits, from their managed third-party capital reinsurance vehicles.
Of course, if there are no benefits, then reinsurers should not be operating this strategy and for some companies this could be the case, especially where a managed ILS vehicles has suffered consecutive year’s of losses (as some sidecars had a few years back).
Finally, Ritchie was asked for his views on environmental, social and governance (ESG), specifically in relation to the ILS market.
Here he disclosed that equity investors are largely struggling to see reinsurers as an ESG compatible investment, but are seeing ILS as one, which he views as a slight contradiction.
He stated, “I find it quite interesting, right now, that there appears to be some success in pitching cat bonds, into the ESG classifications.
“But, from the broader investors I speak to, they have a problem with the listed reinsurers as ESG compliant investments because they struggle to understand if they can price climate risk and get ahead of the trend in climate risk.
“That seems to outweigh the negative, in other words, it seems to outweigh the opportunity and the potential role for reinsurers to actually make the world more sustainable.
“I guess what I don’t quite understand, in how this washes out, is that there seems to be some credit being given for cat bonds as a means of making the world more sustainable, but not reinsurers.
“It feels to me like ESG investors are trying to get a free lunch.
“They’re willing to use cat bonds, where the return interval is very much more remote, but they’re not really seeing the opportunity at the level of return intervals make the world more sustainable, where the reinsurers have, I think, a significant role. But investors are not really seeing that right now.
“So, I think the answer is there is a lot of potential for the whole industry, the whole parts of the risk transfer curve, to participate in making the world more sustainable. But right now a lot of skepticism because that’s getting mixed up with the whole issue around frequency of losses price adequacy etc.”
This is again a fascinating insight into how one part of the capital markets, those who more typically invest in the equity of major reinsurance firms, views reinsurers, versus ILS, through their ESG lenses.
It suggests the ILS market may have an opportunity to capitalise on this, by demonstrating the performance of more remote-risk, higher-layer ILS, such as catastrophe bonds, while continuing to work to improve the ESG characteristics of the underlying assets at the same time.
Meanwhile, for the reinsurers, there’s a clear need to get a handle on frequency and to demonstrate that to their equity investors.
Ritchie’s comments are fascinating and provide a lot of food for thought, at this critical time in investor motivations, especially when it comes to the cost-of-capital and ESG points.
It shows the ILS market is certainly making its presence felt, while reinsurers perhaps need to do a lot more on transparency and make it clearer to their key investors how they are using modern market forces to enhance their business structures and models, as well as how they intend to keep their pricing aligned with the movement of climate risks and the frequency of loss activity.
Of course, the ILS market also needs to stay on-top of pricing, to demonstrate to its investors that loss costs are being covered adequately. So this is a challenge facing all sides of the market.