ILS investors should beware the ‘benign cat environment’: Arch CEO

Investors in insurance-linked securities (ILS), catastrophe bonds and other catastrophe risk investments should not get complacent due to the “benign cat environment” of recent years, and should view performance over the longer-term, according to Arch Capital Group’s CEO.

Warning that investors in the reinsurance sector need to look at performance of their investments over a longer horizon, than simply the recent benign period of catastrophe events when returns have been good, Dinos Iordanou commented “in this risky business you can only know how well you’ve done when 30 or 40 years go by.”

Constantine “Dinos” Iordanou, the Chairman and CEO of insurance and reinsurance specialist Arch Capital Group Ltd., spoke yesterday at the Marsh & McLennan Young Professionals’ Global Forum 2015.

He discussed the evolution of the reinsurance industry capital base, referring to four “waves” where new capital flowed into the sector. He began with the 1980’s liability crisis which prompted the birth of companies such as ACE and XL, private equity backing the classes of 2001 and 2005, the acceleration of ILS capital from third-parties entering the sector and the hedge fund reinsurer trend.

On insurance-linked securities (ILS) and reinsurance as an asset class in particular, Iordanou said that investor comfort has been growing alongside the development of more robust and full-featured catastrophe risk models.

“The acceptability of the [catastrophe] models that a lot of the ILS tools are based on is more acceptable now to the market and to investors,” Iordanou explained.

Here he is likely referring to catastrophe bonds which are marketed with a view of risk from one of the leading third-party risk modelling firms. Of course how investors and ILS managers interpret that view, apply their own modelling factors and underwrite the deal is much more complex.

But Iordano is right that a growing acceptance of modelled views of risk aids investors with portfolio decisions and helps to make large institutional investors more comfortable with insurance or reinsurance risk as an asset class.

“For that reason I believe these kind of capital commitments will continue for the future, based on the comfort level the investor community has,” he continued.

But he cautioned about complacency due to low catastrophe losses; “The benign cat environment leads to good returns for those who have invested in this sector, when you compare it with how the S&P 500 has done and corporate bond index.

“The biggest exposed area that a lot of these ILS and cat bonds have been issued for, which is Florida, has not had an event since Katrina, Rita and Wilma in 2005 – almost ten years without a major event.”

And called for investors to view their returns from investments in ILS and reinsurance over a longer horizon; “Performance is good, but in this risky business you can only know how well you’ve done when 30 or 40 years go by.”

Iordanou continued; “When there are no losses, people enjoy returns and sometimes they forget what risk they take.”

And suggesting that further compression of returns could be ahead, Iordanou said; “Competitive forces have created a thinner probability of profit for participating in these kinds of instruments over the past few years, and the trend continues to be negative.”

Of course that negative trend is also impacting traditional reinsurance companies, including Arch, and the pressure and compression on spreads and returns is affecting their ability to maintain profits.

The warning of taking a longer-term view of the risks and rewards in ILS and reinsurance investing are sound advice which should be heeded by ILS investors and equity stakeholders in traditional insurance and reinsurance companies.

It’s easy to get complacent when times (and returns) have been so good.