Global reflation positive for re/insurance, ILS & cat bonds: Twelve Capital

The global economic trend towards reflation as the world recovers from the pandemic and deals with the fall-out of significant fiscal and monetary easing is expected to be largely positive for insurance and reinsurance sector fundamentals, with some positive effects for insurance-linked securities (ILS) and catastrophe bonds as well, Twelve Capital has said.

Specialist ILS and reinsurance investment manager Twelve Capital believes that the reflationary trend is likely to be one of the “most significant investment themes in 2021.”

“Inevitably, this reflation dynamic will have many and varied impacts on insurance investments managed by Twelve Capital. In aggregate, Twelve expects the impact of reflation to be positive for insurance sector fundamentals,” the investment manager explained.

With interest rates and inflation expectations on the rise, Twelve Capital believes “these moves signal a shift in market consensus expectations of near and medium-term economic conditions.”

For the life insurance sector, Twelve Capital notes that “higher interest rates are a meaningful net benefit for many life insurers.”

“First, reinvestment yields remain generally below running yields on surplus capital, representing an earnings headwind which would lessen as the yield environment improves,” the investment manager explained.

Adding, “Second, many life companies, particularly in the US and many countries in continental Europe maintain legacy books of spread-based business where crediting rates are largely at minimum guaranteed levels, creating additional pressure.

“Third, higher interest rates would lift pressure on balance sheets for products with unhedged long-term implicit or explicit interest rate guarantees, e.g. long-term care and universal life with secondary guarantees. Such balance sheet benefits would be reflected more in improving solvency ratios or less reserve pressure rather than a near-term lift in operating earnings.”

A particularly rapid rise in interest rates could cause more issues, in terms of a spike in lapse rates on existing products, but Twelve believes this to be less likely right now, “given high guarantees on older products and surrender charge protection on more recent production.”

Inflation trends could be a headwind for primary P&C insurance and also reinsurance carriers though, due to an increase in loss cost inflation.

However, Twelve Capital notes that loss cost inflation is only loosely linked to economic inflation, with many other factors at play and both insurance and reinsurance markets can respond to this by charging higher rates themselves, as has been seen in regions like Florida.

While a significant inflation spike could cause more of an issue, the investment manager says, “Twelve believes the trading environment is sufficiently positive to support the necessary premium rate increases to offset this impact. Also, most P&C policies are re-priced every six to twelve months, giving underwriters the ability to react to changes in the inflation environment so long these changes are relatively gradual and well telegraphed.”

On the interest rate side, with most P&C insurance and reinsurance players managing relatively short-duration portfolios, low interest rates have therefore been a headwind and so increases can be beneficial over the mid to longer-term on the asset side.

“A move higher in rates would quickly feed into higher interest income for most companies, particularly in short-tail lines such as personal auto as well as personal and commercial property,” Twelve Capital explained.

Moving onto insurance-linked securities (ILS) and catastrophe bonds, which Twelve Capital says “have minimal sensitivity or exposure to interest rates or broad inflation trends.”

Here, the most obvious effect is the floating rate nature of most ILS and cat bond investments, and given how their collateral is invested you expect the risk free component of the total return to rise in an inflationary and rising interest economic environment.

This has already been seen to a degree, with floating rate returns already up on previous years.

Higher risk free rates can help to make ILS and in particular catastrophe bonds more attractive, especially the lower-risk variety that sit higher up in reinsurance towers.

Higher risk free rates can even make it easier to get a lower price on the risk bearing component of low expected loss catastrophe bonds, so can be positive for sponsors too, as investors gain more compensation from the risk free side.

In addition, the higher inflation related factors that cause social inflation are generally getting priced in, resulting in higher risk spreads on catastrophe bonds and ILS, Twelve Capital notes.

There are benefits to be found in credit strategies as well, Twelve Capital notes, as well as in insurance and reinsurance equities.

Which overall makes the multi-asset approach, of allocating across the insurance and reinsurance balance-sheet, appealing right now.

Twelve Capital explained, “Multi-asset strategies benefit from each of the dynamics described above, including relatively short duration fixed income investments, exposure to improving risk spreads in ILS and Cat Bond investments, and exposure to insurance equities positively geared to rising interest rates.”

On top of this, these multi-asset insurance and reinsurance investment strategies, that include ILS and catastrophe bonds, can shift assets across classes to benefit from the effects of the reflationary environment, as well as enabling investors to benefit from a natural level of diversification between them, Twelve Capital notes.

The reflationary economic environment may be only just beginning, but overall the outlook from it is largely positive and in ILS and catastrophe bonds it will drive higher total returns and overall be beneficial for investors.