One of the top priorities in 2022 so far for insurance-linked securities (ILS) markets and those structuring ILS instruments such as catastrophe bonds has been a focus on inflation, as the market endeavours to adjust offerings to account for it, according to Swiss Re Capital Markets.
With the economies of the world having moved into higher inflation post-pandemic, while issues related to supply-chains persist, social inflation is growing, climate change is inflating loss costs and frequency of severe weather seems on the rise, the reinsurance and ILS industries have a job to do on controlling inflations effects, as well as ensuring it is priced for.
Swiss Re Capital Markets explained in its latest ILS market report.
“With inflation being a significant concern for investors and sponsors alike, it is important to understand the dual impact of inflation on the ILS market.
“Increased claim costs (replacement costs for raw materials and labor costs) have created higher ultimate loss amounts for indemnity-based structures in both the traditional reinsurance and ILS market,” the company said.
Adding that, “The implication of inflation on expected losses is not uniformly captured in the risk models, therefore inflation adjustments have become a key area of focus this year.”
The ILS and catastrophe bond market has been trying to ensure inflation is accounted for in the exposures it underwrites and deploys capital against.
This has led to a need for increased diligence on transactions, as ILS managers and investors require additional disclosure to understand how inflation has affected the portfolios they are providing reinsurance against.
Swiss Re lays out some of the ways the ILS market is dealing with inflation.
“Some issuing sponsors have chosen to provide investors with projected insured value data based on an upward trajectory of inflation.
“As a result, investors sought to gain insight to better understand inflation assumptions taken by sponsors. In some cases, this led to increased scrutiny of growth strategies and whether insurance penetration was increasing at an appropriate level in catastrophe prone areas.”
On top of this, inflation has been impacting risk interest spreads, as increased claims costs lead to larger amounts of notional being issued, Swiss Re Capital Markets points out.
While this also affects investors demand for returns.
“Besides the impact of loss amounts, inflation also leads investors to require higher nominal returns to maintain their real returns. Since most cat bonds use a floating rate – typically money market funds plus a fixed spread – the nominal returns naturally increase with rising interest rates.
“This partially ensures both higher nominal and less heavily impacted returns when inflation increases,” the company said.
The increase of nominal returns looks set to persist, as Central Banks increase interest rates to combat inflation.
Swiss Re said, “Central banks have largely communicated rate rises to combat inflation, which was in part exacerbated by government stimulus plans and supply chain interruption. However, the reality of inflation increasing beyond already historically high levels is forcing central banks to accelerate interest rate hikes, particularly in the US, UK, and Euro zone.”
Which makes the floating rate nature of catastrophe bonds perhaps an even more attractive draw for new investors and could serve to attract more capital to the market over time, through an elevation of the total return of catastrophe bonds and other ILS investments.