While catastrophe bonds have proven extremely attractive over the last year and a half and there has been an evident shift in some investor allocations to these more liquid insurance-linked securities (ILS), it is important to provide some context and explain that some investors are also shifting the other way.
It’s not as if every investor or manager finds catastrophe bonds more attractive right now.
In fact, some specialist ILS investment managers regularly shift allocations to different types of ILS structure, depending on market conditions, with cat bonds one of the most liquid it is an area of the portfolio as easy to reduce in size, as it can be to increase.
When a lot of capital poured into the catastrophe bond market this year it softened pricing and that has been enough to send some fund managers and investors, especially those with diverse ILS allocations that they more actively manage, the other way.
Investors have shown increased appetites for the more liquid, transparent and often predictable nature of the catastrophe bond structure, over other areas of ILS fund investments like collateralized reinsurance and retrocession, over the last year or so.
This reallocation of ILS investor capital, or shifting of investor priorities, was driven by unexpected losses and uncertainty surrounding private ILS and collateralized reinsurance, which has subsequently played into the hands of some of the larger cat bond funds, helping them to expand significantly over recent quarters.
Of course, this reallocation of investor funds has also helped to support the strong issuance seen in the cat bond market, as new sponsors turned to cat bonds as a risk transfer tool.
Aon said recently that it expects this shift will continue, with more investors focusing on catastrophe bonds over the coming quarters.
But we don’t expect this shift to mean a lack of capital in the other areas of the ILS market, as still collateralized reinsurance, sidecars, quota shares and industry loss warrants (ILW’s) have significant value for the dedicated specialist ILS manager-run funds and more sophisticated ILS investors.
As soon as the cat bond market started to soften earlier this year, some ILS managers began to turn their attention to the reinsurance and private ILS market, as opportunities emerged to deploy more capital, as some additional capacity from the market had been diverted to cat bonds.
This provided a chance for better returns to be secured as well and we hear from sources that some managers are attributing success at the mid-year reinsurance renewals as being partly down to more capital having been deployed away from those negotiations and into the cat bond market.
As one example, the quota share and sidecar space has had some particularly attractive opportunities in recent months, partly due to capital having been diverted away, but also as some suffered significant losses over recent years and didn’t renew, meaning the sidecars and quota shares that have persisted are often of higher quality.
In addition, private ILS and collateralized excess-of-loss reinsurance have both seen particularly attractive opportunities available for the managers able to secure them.
This has especially been true for managers that have their own reinsurance vehicles, which can make it simpler for cedents to transact with them.
We understand some ILS fund managers feel the quality of deals they underwrote at the mid-year renewals in 2021 have been particularly high, after a few years where the market has shaken out some of the poorer quality deals, while the shift of capital to catastrophe bonds meant better terms could be secured in a number of cases.
Of course, some of these same ILS managers have cat bond strategies that they have also grown in size.
But some are more focused on their ILS funds that invest across all ILS assets and it is these that have, in a number of cases, seen the cat bond component of their funds pruned, in favour of more quota share or collateralized reinsurance business, in reaction to recent cat bond softening.
Of course, this is all just an example of managers, investors and underwriters reacting to ILS and reinsurance market dynamics. Going where the most appropriate, attractive and highest quality opportunities to deploy capital are and, of course, you are always going to get differences of opinion and strategy.
It’s also an example of ILS managers looking to generate alpha for their investors, by selectively choosing the segments of the ILS market that are most appropriate to allocate to depending on availability of product and market conditions.
This is what makes the ILS market a vibrant place to invest, as strategies do differ and managers are constructing portfolios with very different return potential, alongside different levels of risk exposure, across expanding lines of insurance business, so offering a wide range of outcomes to suit investor appetites, needs and levels of risk aversion.
Of course, catastrophe bonds remain very attractive and the larger cat bond funds are likely to expand further this year, if issuance lives up to expectations.
Many major institutional investors find the fully-securitized, more liquid nature of cat bonds the most appealing point of access for ILS returns.
But those ILS managers who also focus on private ILS deals and collateralized reinsurance are also expecting to see attractive opportunities to deploy their capital as well, meaning some may continue to reduce their cat bond focus if that side of the market remains softer over the coming months.