Investment banking giant Goldman Sachs believes that investors are not fully appreciating how the changes to terms and conditions in property reinsurance will affect the outcome for reinsurers and other insurance-linked investments, feeling that the changes can drive strong additional returns for constituents.
Rates and pricing get all the headlines in reinsurance, but as we’ve been writing for years the terms of coverage can be just as important for the eventual and hopefully profitable outcome, for those allocating capital into the reinsurance industry.
Let’s take a step back, to 2017, when brokers were keen to push the fact that the insurance-linked securities (ILS) market and traditional reinsurance had converged on terms.
That was at the bottom of the soft market, when rates had tumbled and returns in reinsurance were significantly eroded, but the way terms had been stretched made the outcomes even worse for capital providers.
That convergence on terms was a positive, for the ILS product offering, in being more comparable with traditional covers. But it fails to tell the story of terms elasticity, as key conditions of reinsurance coverage, from the hours clause, to the way perils were named or included under broad categories as “other”, made a huge difference to the outcomes for both traditional and alternative sides of the market later that year.
Terms were eroded significantly at renewals through 2014 to 2017, with concerns already being raised back in 2015.
From 2017 on, catastrophe loss events began to show up some of the issues that the industry had created for itself, through the relaxation of terms.
The hours clause was an area that evidenced this, as well as the proliferation of aggregate covers with low deductibles, the generally lower attachment points on occurrence reinsurance covers, and the widening of coverage away from explicitly named perils.
In the ILS market, this sector was also grappling with widened terms around ILS-specific features related to collateral and trapping, the famous buffer tables, which combined with the coverage terms expanding drove some really significant challenges.
All of this came to a head through 2017, 2018 and 2019 catastrophe events around the globe, with losses passed on to the reinsurance and ILS market in greater quantities than had been seen perhaps ever before (when we say quantity, we mean the percentage of losses passed on to reinsurance).
Which meant primary insurers skin in the game had been greatly reduced, while on the retrocession side traditional reinsurers were also readily able to pass on a lot of their losses from catastrophe events through these years.
By 2019, it was increasingly evident things needed to change, with many recognising that terms and conditions were just as important as rates at the renewals, in determining the chances of a profitable outcome.
At the same time, ILS funds and investors became increasingly focused on improving the terms related to collateral trapping, release and rollover, as these had also been relaxed significantly through the soft market period.
Come 2020 and an evident shift in risk appetites was also occurring, as we reported that insurance-linked securities (ILS) fund managers were looking to capitalise on the hardening market in more ways than just price, to ensure their portfolios could deliver better returns and become less volatile.
Moving up in reinsurance towers, tightening terms, reducing unmodelled coverage, ensuring perils are more tightly described, a renewed focus on occurrence covers, and a continued push to tighten collateral terms as well.
All of which promised a higher return potential for the average ILS portfolio, as long ago as 2020.
The improvement of terms continued at the renewals in 2021, with continued focus on buffer loss clauses as well.
Then in late 2022, the end of year renewals for January 2023 saw this trend going even further, with attachment points doubling in some cases, while hours clauses were shortened, driving some challenges for brokers in clearing the renewal placements.
The mid-year 2023 renewals saw a more relaxed environment, more of a case of holding the terms and conditions line, rather than trying to install even more onerous contracts on ceding companies.
All of which had been happening through the traditional and alternative sides of the market at the same time, resulting in the much more performant reinsurance portfolios that we see today.
So we’ve been documenting these changes to terms and conditions for years now, but Goldman Sachs believes that they continued to be underappreciated by the investors and capital providers to the reinsurance space.
“While it is no secret that property reinsurance pricing has risen significantly, we think the benefit from terms and conditions changes limiting secondary peril catastrophes is likely still underappreciated and allows for strong base case ROE,” the analysts from the investment bank explained.
Given the greatly improved property and catastrophe reinsurance market environment, Goldman Sachs analyst team say they hold a “favorable bias towards companies that are more levered to the property reinsurance pricing environment.”
“The market still under appreciates just how beneficial 2023 terms and conditions changes are for limiting the frequency of smaller, secondary peril, catastrophes,” Goldman’s analysts reiterated.
Calling the effect of T&C improvements “an underappreciated margin tailwind” for the reinsurance sector.
They believe that the improvements in terms and conditions have significantly improved the baseline performance for those able to take advantage of this, something that reads across equally positively for the insurance-linked securities (ILS) market as well.
They explain that, looking ahead, “Terms and conditions are set to stay tight and be significant drivers of earnings going forward as reinsurers re-underwrite to shed secondary peril type risks and take into consideration the potential that certain geographies pose significant challenges for insurance and reinsurance coverage.”
Goldman Sachs analyst team also note that, in catastrophe bonds where spreads have been elevated, this is at least partly down to “investors having more discipline with terms and conditions.”
Summing up, the analysts state that, “For reinsurers to truly return to 20%+ ROEs, not only will pricing need to remain hard, but terms and conditions (an arguably more important metric in the long term) will need to be tightened as well.”
Pricing alone is not seen as sufficient to restore those ROE’s over the longer term though, but the updates to T&C’s can make a significant contribution on top of that.
In fact, the Goldman Sachs analysts calculate that the improvements to terms related to secondary perils alone can drive double-digit percentage increases (nearing 30%) to reported EPS, for reinsurance firms with property as a focus, through the reduction in losses and frequency related volatility in their results.
All of which reads through very positively for the ILS community, where the terms and conditions improvements are a significant driver of the performance being seen so far in 2023, as many ILS strategies have avoided any meaningful losses, despite an active year for severe weather and catastrophes.
The T&C updates have reduced what were once losses that could wipe out a months worth of returns, or more, to events that drive only attritional impacts to ILS portfolios, putting the sector back into its more comfortable home as a capital source to absorb losses from peak catastrophe events, rather than a capital source that takes on volatility and frequency losses in spades.
The investor base in ILS needs to see more data to support this, perhaps information that can help them understand how an ILS fund strategy might perform today if we saw a repeat of 2017 and 2018.
The difference from how that ILS strategy performed at the time could be stark in some cases, with significantly improved performance, much lower levels of loss, and many strategies still coming out near to and even positive for the year, we suspect.
This is the kind of data investors are looking for right now, to evidence that the ILS fund market’s portfolios are in significantly better shape, not just due to pricing, but also due to the way terms and have become more closely aligned with the appetite for risk that capital providers have as well.
In our discussions with end-investors to the ILS space, both those invested, or with experience investing, and those considering their first allocations, there is a consistent message that understanding how T&C changes could affect portfolio performance has not been communicated to them particularly well.
There’s been a focus on rate and price and how that can drive higher spreads and returns, but investors do want to understand the contribution of contract and structural enhancements, as well as T&C updates. Something for the industry to work on (or at least share more readily), perhaps.