Rate rises + tighter terms + dislocation + quality cedes = higher ILS return potential

Insurance-linked securities (ILS) market return potential is on the rise and in some cases the portfolios constructed, or added to, at the January 1st 2021 reinsurance renewals, are going to offer significantly higher return potential to investors.

The reasons for this are varied and the causes of the situation numerous. But there are a number of key factors that are set to drive higher return potential for ILS funds and investors across the market, not just in catastrophe bonds, but also in private ILS deals and other collateralized reinsurance structural forms.

At its core, insurance-linked securities (ILS) and collateralized reinsurance capacity continues to offer an efficient form of capital for insurers and reinsurers that find their own capital constrained and charged by concentrations of risk on their own balance-sheets.

There comes a point where re/insurers look to other forms of capital, reinsurance and ILS, to lay off risk, rather than hold it, as the charges for holding exposures begin to eat into their return-on-capital.

So the demand remains and will persist, but right now the dynamics in the market mean that ILS return potential is on the rise.

The hardening of reinsurance and retrocession markets:

Well-documented by ourselves and others, the hardening of reinsurance towards the key January 2021 renewal season means rate rises and higher pricing across a significant swathe of the business the insurance-linked securities (ILS) fund market tends to allocate to.

This is being seen across all structures and return-periods, in some cases even for the most long-standing and loss-free of client relationships.

In catastrophe bonds, rates began rising some time ago and at this time appear to have already peaked, with recent transactions pricing down. But still, the returns of new catastrophe bond issuance are well-above where they sat a year ago, providing an opportunity for higher-performing portfolios to be constructed at this traditionally busy time for the cat bond marketplace.

In collateralised excess-of-loss and aggregate reinsurance and retrocession renewals rates are rising in alignment with those seen across the marketplace and there is without a doubt some catching up of rates even in historically almost perma-soft marketplaces like Europe.

In the quota share reinsurance world, pricing has also been seen to increase for many cedents, we understand, again driving higher return potential.

The tightening of reinsurance and retrocession terms & conditions:

Again, well documented and partly stimulated by both the global COVID-19 pandemic and also the explosion of social inflationary loss amplification of recent years, the market is without doubt more risk averse and looking to tighten up where it has perhaps been too loose in the past.

This has driven a focus on named perils within coverage terms as the January 2021 renewals approach, but alongside the introduction of strict exclusions for pandemic risk, where it was never intended to be covered, as well as continued tweaks to terms on issues such as collateral trapping, release and buffer loss tables, all suggests ILS contracts with higher return potential will be written at this renewals.

The dislocation of reinsurance and in particular retrocession markets:

Market dislocation drives opportunity, not just in being able to name your price, but also in being able to renegotiate terms and achieve a cleaner assumption of more predictable risk.

Dislocation creates pockets of opportunity where capacity is not as abundant as it could be, something increasingly seen in the retrocession space and a factor that has been driving some new and repeat sponsor issuance in the catastrophe bond market.

Dislocation also drives opportunities that may not have been seen in previous years, as some cedents look to shore up their protection, or turn to another structure or market.

It can also make alternatives seem more attractive and going forwards potentially drive more cedents to access the capital markets for reinsurance and retrocession.

Better quality cedes:

As technology improves apace, so too is catastrophe risk modelling. At the same time underwriting practices have been tested to their limits in recent years, with many cedents having undergone a thorough reworking for their internal processes and the way they assume risk. At the same time we see claims processes as having improved dramatically, as issues such as social inflation and now the pandemic have forced cedents to adapt and better themselves.

All of which adds up to a higher quality of cession being available from many cedents in the market, than perhaps was seen after the prolonged period of softening.

This is an often overlooked factor, but one that has been changing for the better through the last couple of years.

Diligence on the underwriting and claims side is dramatically on the rise, at least among some cedents, helped partly by the explosion of new technology options to help cedents operate better and more efficiently.

All of which, should, in time, result in cedents constructing better performing portfolios of risk, meaning their reinsurance and retro capital partners should also benefit from better quality cedes coming through to them.

This could be seen most dramatically among some of the more selective ILS funds that specialise in quota shares, as alongside the improvements in terms, pricing and in the dislocated market, could stack up to a significant opportunity to deliver higher returns and more stable performance.

Higher ILS fund returns?

Clearly the way rates are moving and factoring in these other issues, ILS funds should either be capable of delivering higher loss-free returns, or their targeted returns with greater frequency.

Multiples in the catastrophe bond issuance market are up significantly on recent years and the spread available (between expected losses and coupon) from this years catastrophe bond issuance is now the highest seen since 2012.

However, as we said, the peak in terms of catastrophe bond pricing multiples may already have been reached, as recent issuances have begun to price down from their guidance and multiples dropped as a result.

But catastrophe bond funds are extremely well-positioned at this time and looking ahead it seems likely both multiples and spreads remain elevated on prior years for the foreseeable future.

In the collateralized reinsurance and retrocession portfolios of ILS funds, so where the majority of private ILS activity takes place, return potential is also definitely higher and fund portfolios will typically contain a little less risk, at generally higher rates-on-line (ROL) as we move into 2021.

Volatility will also be down somewhat in many of these ILS fund portfolios, particularly for those that do not adjust their targets just because the market is hardening, but keep to their return targets and prefer to reduce risk and volatility in their ILS fund portfolios instead.

Of course, on the other end of the market, those seeking the much higher returns in retrocession and the like, also have a chance to hit their 20%+ returns while taking on a little less risk as well, perhaps making higher return ILS fund strategies also more compelling due to the above factors.

On the quota share side, all of these factors should result in higher priced risks assumed, through better quality cedes, again elevating the return potential of these strategies and also some collateralized reinsurance sidecars as well.

What next?

The question now lies in how long this can all be sustained, especially when we’re already seeing catastrophe bond pricing as likely to have peaked well before the renewals are even reached.

With capital flowing into the industry, there could be some disappointment in the actual levels of rate increases achieved.

But for the ILS fund market, the price improvements won both already and at the upcoming renewals should still make a significant difference to their return potential, especially for those who really know how to maximise the efficiency of their capital markets sourced, third-party investor backed funds.

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