For the insurance-linked securities (ILS) market and global reinsurance capital, this time it’s different, concludes Dirk Lohmann, Chairman, Schroders Capital ILS, who analyses previous hard market periods and believe that we could be on the verge of the most pronounced market correction in decades.
In a recent paper, Lohmann compares the current situation in the reinsurance and insurance-linked securities (ILS) market with three previous “hard market” periods, asking the question “Has Hurricane Ian taken us to the brink of a major reinsurance market correction?”
Lohmann concludes that this time it is different, as a number of factors have driven dislocation and there are more than just catastrophe losses at play.
In particular, Lohmann looks at the role of the capital markets and investors in recapitalising the reinsurance industry, both through equity and ILS routes and here finds that 2022 and ahead into 2023 could be different as well, as both the sentiment or desire to and the means to replenish the industry may not be as abundantly available.
By market correction, Lohmann is referring to what he explains as a “material shift upwards in risk transfer premium, in the reinsurance and insurance linked securities markets (ILS) due to a shift in the supply and demand of risk bearing capital.”
He analyses three hard reinsurance market periods, following hurricane Andrew, the 9/11 terror attacks, and after hurricane Katrina, Rita and Wilma and for each looks at the extent to which losses were modelled or anticipated, the strength of the reinsurance balance-sheet at the time, and the response of the capital markets, in terms of equity capital or allocation to ILS instruments.
A number of factors affecting the market in 2022 lead Lohmann to feel that this time it’s different, as all point to the potential for market dislocation, capital depletion and hardening.
These are: the fact 2022 is set to be another heavy loss year, including hurricane Ian; the fact prior year’s loss activity was already hardening reinsurance and ILS pricing; the fact the re/insurance industry balance-sheet is being impacted by macro-effects and inflation; and the fact the capital markets appear less willing to respond to the reinsurance industry’s capacity needs this time around.
“Schroders Capital’s ILS team believes that the answer to the question is yes, we appear to be on the brink of a major market correction,” Lohmann states.
Lohmann’s paper explains that all the signs were there for market hardening at 2023’s reinsurance renewals even before hurricane Ian came along, with dented capacity, inflation that is increasing demand for reinsurance, and an ILS market still working its way out of multiple year’s of catastrophe losses.
The general consensus was already that firmer pricing was ahead, with the conversations in the market more about whether capacity would be sufficient, than whether pricing could be influenced.
Lohmann explains that market corrections, of the magnitude that may be ahead of us, are “infrequent and rarely triggered by a single event.”
In this case, there are numerous forces coming together to drive a hard market in reinsurance and ILS, which of course are also set to drive returns and yields higher, resulting in some of the most attractive market conditions in some years for capital providers.
“The market was heading for hard market territory even before Hurricane Ian. There is now a broad expectation in the reinsurance market that the reinsurance premium index will show a steep onwards curve upwards going forward,” Lohmann writes.
You can see that the catastrophe bond market had already been hardening in our chart of average cat bond coupons and spreads.
But Lohmann says that it is more than just losses driving the correction this time around, “Coming into the 2023 renewal, a large volume of catastrophe losses – in 2022 and preceding years – combine with a new and differentiating aspect: The impact of the high inflationary environment.”
There is a broad-based increase in demand for reinsurance capacity, with Lohmann suggesting catastrophe reinsurance limits are expected to grow by 10%, while at the same time we have changing modelled views of risk that can also stimulate demand.
Another factor that is different this time, is that the catastrophe bond market’s loss is set to be more meaninfgul after hurricane Ian, than has ever been seen before.
Lohmann notes that, “In prior years (specifically 2005, 2011 and 2017) the catastrophe bond market suffered modest losses and ended the year on a positive basis (gross, before fees, using Swiss Re Global Total Return Index). 2022 may be the first time in its history that the catastrophe bond market ends with a loss for the full year.”
The state of the reinsurance industry’s balance-sheet is a significant factor, with year’s of losses and a lack of profits now exacerbated by macro-economic effects, inflation, possible reserve limitations becoming evident and finally Ian.
Capital market conditions are another key factor influencing the ability of the re/insurance industry to attract new capacity and for the ILS market to attract new investors and inflows from existing, even absent catastrophe loss events.
Lohmann highlights that the situation in the capital markets in 2022, “has resulted in a markedly changed situation for the (re)insurance industry.”
Continuing to explain that, “The prospect of further interest rate hikes and uncertainties over the impact of inflation on incumbent (re)insurers’ reserve adequacy have served to act as inhibitors for both public and private equity markets to invest in existing balance sheets.”
He points out that the amount of risk-bearing capital in the re/insurance industry, including alternative capital, seems to be reversing a trend of steady growth at this time, for all of the reasons mentioned above.
Hurricane Ian has disrupted what was shaping up to be a good year for the ILS market, Lohmann says.
Underperformance is causing investors to question the thesis of ILS, while investors are in some cases being troubled by their asset allocation protocols, as we’ve previously explained.
Beginning to sum up, Lohmann says that, “Major headline losses are an important, but not the only, determinant in triggering a broad market correction.”
There has been increasing pressure building up in reinsurance and ILS over the last five years, but in 2022 we’ve seen a harder January renewal season, the challenges in sufficiently funding the cat bond pipeline earlier this year, the difficulties around the Florida renewals and the evident hardening at mid-year, plus inflation, macro-economic effects to investment portfolios of re/insurers, and the potential for reserve related deficiencies also potentially rising.
Reinsurance capital is in decline at the same time as reinsurers’ appetites for catastrophe risks are limited, dwindling and some cases already filled.
“Finally, unlike the previous market corrections, it does not appear that the capital markets, particularly those that have funded the alternative capital (ILS) sector, will be in a position to respond to the needs of the reinsurance industry,” Lohmann believes.
Concluding that, “Taking all of the factors discussed above it seems to us that 2022 is indeed different from the immediately preceding years and that we may be at a tipping point and possibly the most pronounced correction in decades.”
We’d recommend you read the full version of this excellent paper by Dirk Lohmann, which you can find via a Linkedin post here.