In our discussions with managers of insurance-linked securities (ILS) funds and other collateralized reinsurance structures around the mid-year renewal season, one fact that has become increasingly clear is that many ILS fund managers are taking the opportunity supplied by the improved rate environment to move higher up the risk tower.
One of the trends we’ve been following over the last two years as reinsurance and retrocession rates have been firming, is the fact ILS fund managers and other providers of fully-collateralized solutions, have been working to improve the terms and conditions on contracts.
This has been especially apparent in areas of the market where capital has been more constrained, resulting in ILS funds improving the return profiles of their portfolios and funds.
But in 2021, this trend of refocusing and improving the quality of ILS fund portfolios has shifted to a layer focus as well, with increasing amounts of ILS capacity targeting higher layers in reinsurance towers.
With the hardening of reinsurance, it is now possible to deploy capital into higher layers of risk for roughly equivalent returns of lower layers a few years ago.
This means ILS funds have been able to adjust their risk-return profile somewhat, reducing risk, or exposure to frequency type events, for example, while still maintaining their ability to generate target returns for their investors.
After recent heavy loss years for some ILS funds, the shift to improve terms (particularly around collateral and the potential for it to be trapped), to reduce aggregate or frequency loss event exposure and now the move higher up in the risk tower should all combine to present a higher chance of making target returns, even in an average catastrophe load year, we’re told.
The shift to higher layers of reinsurance towers is not just being seen in the excess-of-loss segment of the market. We’re also told that quota shares have seen ILS capacity providers moving their participation to higher layers or attachment points.
By moving a little higher, into slightly more risk remote layers, the ILS fund managers are able to control their exposures, reduce uncertainty in the fund’s performance as well, while attempting to deliver more stable returns.
The hardening of reinsurance had enabled these shifts in strategy. It remains to be seen how sustainable the rates will be at these higher layers, particularly with strong competition from the catastrophe bond market for higher layers of risk as well.
We are told that not every ILS fund is being cautious in these moves higher up, in protecting returns at previously advertised levels.
We understand that there are a handful of investment managers that have been incredibly honest with their investors and explained that returns could be ever-so-slightly lower after a shift up the risk tower, but at the same time explaining how much better insulated investor capital is from certain catastrophe event scenarios, particularly smaller or more frequent events.
That’s a shrewd strategy for some, as there are collateralized reinsurance focused ILS funds that in cleaner years have been far outperforming their advertised targets. So a slight shift down in target, for a better protected and slightly more risk-remote strategy, seems like a good trade-off for end-investors.
However, it’s not always essential to shift targets downwards, as by being more selective overall, better quality lower layers can be invested in alongside a focus on more remote risk, maintaining returns but also insulating the portfolio better.
Of course, not everyone is moving up the tower and where ILS capital moves up, it’s not just traditional capital filling the gaps, there are always ILS players ready to take some of those lower, more working reinsurance layers as well.
It’s another interesting trend though and shows ILS fund managers moving with the market and its pricing, while managing their strategies to minimise the chance of losses and moderating impacts when catastrophes do happen.