Risk adjusted returns of ILS need to remain appropriate: A.M. Best

The insurance and reinsurance linked investments space has value for its investors, as a diversifying asset with low correlation to broader financial market indicators, but this value is lessened or wiped out completely if the risk adjusted returns of ILS are not appropriate.

Rating agency A.M. Best touches on what is a very important consideration for ILS investors in a recent report, the importance of delivering appropriate risk-adjusted returns.

The rating agency notes that the ILS asset class has continued to demonstrate the value it can bring to major institutions as an investment class, even after the major catastrophe losses of 2017.

The 2017 catastrophe events were largely within modelled expectations which meant that ILS funds and alternative capital vehicles have been able to reload effectively, dispelling the previously held myth that at the first sign of trouble the investor base may head for the hills.

But instead, the ILS fund sector reloaded, replacing trapped capital was the first part of this but then many players actually raised more so they could build larger portfolios at a time when rates had at least ticked up in January.

Investors raised their return expectations somewhat following the losses they were exposed to and in the main there does appear to be an uptick in ILS fund returns beginning to flow through from many managers, although the continued loss creep from hurricane Irma has pushed this further back for some.

As this loss creep continues to affect some managers we are going to see some fluctuation in ILS fund returns and some differentiation between strategies, but as long as the managers are underwriting fresh business at appropriate risk-adjusted returns, then the benefits of the slightly improved rate environment will eventually begin to show.

A.M. Best notes that another bad hurricane season could change the dynamic slightly as, “A second year of substantial catastrophe losses in the near term might cause a more serious disruption to the flow of capital from alternative source, leading to some capital shortage.”

But, even if this does occur, A.M. Best says, “The uncorrelated nature of the industry to traditional investments does appear to have value—so long as the overall risk-adjusted return remains appropriate.”

Of course what are appropriate risk-adjusted returns for one underwriter of insurance and reinsurance risks may not be the same as another’s.

Different strategies, between traditional and alternative capital, but also within the ILS market as well mean some can soak up lower rates than others.

When looking at risk-adjusted rate adequacy you also need to look at the efficiency of the underwriting capital writing those risks. For example a major global reinsurer can write business at levels close to modelled expected loss, while a less diversified ILS fund cannot.

But then expected loss is largely a metric that everyone has a different opinion on as well, so identifying the risk-adjusted appropriateness of an underwriting return is extremely difficult, individual and reliant on many factors.

Perhaps a better way to put this would be that the return on deployed underwriting capital needs to be appropriate to the individual, which goes for ILS funds and their collateralized investments, or re/insurers and their shareholder backed balance-sheets.

As other efficiency efforts, such as technology related, risk placement, distribution focused, or capital derived, continue to flow through the market, comparing the appropriateness of pricing across the market is going to become increasingly difficult, as the levels of efficiency of operations and capital are likely to diverge from player to player and strategy to strategy.