Huge catastrophes won’t drive capacity shortfall thanks to ILS: KBW

Thanks to the sophistication of the insurance-linked securities (ILS) market and investors demonstrated resilience over recent loss-heavy years, analysts at KBW conclude that even huge catastrophe events won’t drive a capacity shortfall in reinsurance any more.

It’s another of the interesting points from a recent report by KBW’s analyst team led by Meyer Shields, who spoke with reinsurance market participants around the virtual replacement for the Monte Carlo Rendezvous.

The KBW analysts question whether the current market trend towards firming, which they see as earnings-driven right now because of factors related to losses, loss amplification and rising frequency of cat losses, plus the low-yield environment, could turn into a capital-drive hard market for any reason.

But they say probably not.

The reason being that, “ILS investors’ resilience and sophistication implies that even huge natural catastrophe losses – well beyond even this year’s sizable and occasionally-surprising losses including Winter Storm Uri, German/European floods (estimated at about €7 billion), Hurricane Ida (most, but not all executives expect this in the lower half of the $25-35 billion range, based on comparisons with Hurricane Katrina), west coast wildfires, significant hailstorms, etc. – would probably not drive a capacity shortfall.”

In fact, most of the reinsurance executives KBW’s analyst team spoke with said that a casualty shock would be the kind of event required to drive a capacity related issue for the industry, that further stimulated firming.

KBW’s analysts noted that, “Limited ILS participation beyond short-tailed lines implies that lost capital supporting casualty lines wouldn’t be rapidly replaced, but inflecting loss trends for long-tailed lines take longer to identify (and management teams have more discretion over acknowledging their impacts), so we expect incremental – rather than abrupt – expected return improvement.”

One of the originally cited benefits of the ILS market and its growth was the fact the capacity should be relatively permanent, but also flexible, and if there was any shortfall in traditional reinsurance capital, in the lines of business ILS underwrites, then the capital markets should be able to quickly fill it, as long as rates were commensurate.

So, perhaps we’ve now reached a stage where with the ILS market representing some 15% of global reinsurance capital and having recovered to its previous high of around $97 billion, it’s increasingly unlikely the ILS portion declines significantly and increasingly likely that if the traditional portion shrank in the shorter-tailed lines, ILS could replenish it.

Which is what the capital markets have always been designed to do, quickly fill gaps in capital and enable industries to provide greater continuity to their clients.

With more and more re/insurers managing ILS capital as well, we should expect that sometimes, when traditional capital is eroded, re/insurers might choose to replenish that on their third-party capitalised balance-sheets instead.

ILS and the capital markets are therefore a buffer for global insurance and reinsurance capacity and an important piece of providing continuity of coverage to reinsurers, insurers and policyholders alike.

Of course, it’s important to note that ILS investors want to be paid returns that are commensurate with the risks they are assuming, so for ILS capacity to be perpetually available the industry really needs to ensure it keeps its pricing pencils sharpened.