ILS funds shift to more remote layers & tighter terms in hard(er) market

As well as enhancing their returns thanks to rising pricing, insurance-linked securities (ILS) fund managers are seeking to capitalise on the hardening reinsurance and retrocession market in a number of other ways that could result in their portfolios delivering better returns and becoming less volatile.

We’re as guilty as most observers of the market in focusing on rate as the key motivator and opportunity in ILS and across reinsurance or retrocession.

But, as we’ve explained previously, it’s not all about rates and pricing, there are other factors that play into making an ILS investment a more attractive opportunity and the returns it can eventually deliver, meaning ILS fund managers have a number of levers at their disposal during the current period of market firming.

With risk adjusted catastrophe bond pricing having noticeably moved upwards this year, while rates at the June 1st reinsurance renewals have risen strongly and the July 1st renewals are expected to see further attractive rate increases a number of ILS fund managers are taking this opportunity to effectively dial down risk, while regaining more control and certainty over the contracts they underwrite and allocate collateral to.

Over recent years, some ILS fund managers and investors have been subject to gradually more onerous terms, when it comes to collateral release and other key contractual issues, while the coverage they’ve been providing has often broadened as well.

In particular the continued push towards cascading and aggregate structures, in reinsurance and retrocession, has resulted in ILS returns being diluted to a degree, while at the same time the collateral has been subject to increasing chances of being trapped as well.

Nowhere has this been more apparent than in the reinsurance quota share and sidecar space, where terms have significantly moved in the favour of sponsoring companies over the last few years.

This all began to change towards the end of 2019, as the repeated years of losses gave a chance for ILS markets to push back on some of the more onerous terms, especially related to buffer loss tables and collateral clauses.

Now, with the market hardening much further and the threat from the Covid-19 pandemic having seemingly refocused minds, the ILS market has been able to push-back more and recover some of the lost ground in recent weeks, when it comes to terms and conditions.

At the same time, ILS fund managers and investors are also shifting to higher, more remote layers of programs, where they can, as another lever available to them that can help to improve their portfolio returns.

In the current market environment, even a slight shift up the layers of the reinsurance tower can deliver improved risk adjusted returns.

Combine this with products that are more regularly occurrence based and some ILS funds are making their portfolio risk curves increasingly favourable for their investors.

Add in enhancements to terms and conditions and it’s easy to see that some ILS portfolios may be a lower-risk investment prospect that has even higher-return potential at this time, which is a win for the fund managers and the institutional investors backing them.

As prices rise, some ILS fund managers try to move to more risk-remote layers, to optimise their chances of hitting their return targets over the year. Using terms and conditions to achieve this as well, means some ILS portfolios could have a quite dramatically improved return potential at this time.

The hardening of reinsurance and retrocession markets may ultimately serve to improve the risk adjusted returns of the entire ILS market for a time, as long as rates continue to hold up and do not tumble back to the levels seen in 2018 and early 2019.

ILS fund managers will be keen to install a new pricing floor, as reinsurers are as well, with these combined efforts perhaps serving to enhance the returns of ILS for end-investors for some months and years to come.

The wild-cards will be capital inflows and efficiencies, as any flood of capital flowing in will naturally dampen rates and perhaps put the hardening into reverse.

At the same time, any significant advancements that enhance the efficiency of capital being deployed into reinsurance and retrocession could also serve to lower the price, or returns.

But we’d hope (in a functioning marketplace) that on a risk-adjusted basis this would be less impactful to investor returns, as efficiencies should drive costs out of the entire market and ILS transaction chain, not just out of the capital.