Rush to allocate capital creating a soft ILS market: Lane Financial

The market for insurance-linked securities (ILS) and catastrophe bonds is already beginning to resemble a soft market, as evidenced by the pricing of recent deals. Take into account the levels of excess capital in the insurance, reinsurance and ILS sectors, all are capitalised to very healthy levels and the ILS market continues to receive new inflows from investors, and it looks like an even softer market could be ahead of us, according to the latest report from Lane Financial LLC.

The report from Lane Financial, a consulting firm focused on the intersection of the reinsurance and capital markets since 1995, contains its annual review of the ILS market and unique insights that you won’t find elsewhere. Lane Financial runs its year for reporting purposes from the end of Q1, so the numbers differ to other reports, but it’s not the issuance volume trends that matter here it’s the underlying ILS and cat bond market factors such as the tail, returns, yield and expected loss which are tracked in detail.

The report begins with a look at the recent pricing and rate trends in the ILS and cat bond market which Lane Financial suggest is already a soft market, but also likely to soften further. Lane Financial believe that the softening trend evidenced by pricing of recent ILS and cat bonds versus traditional reinsurance is a trend we’re likely to see continue while the insurance and reinsurance markets are well capitalised and the ILS market continues to see strong interest and inflows from investors.

This softening trend won’t be welcomed by some traditional reinsurers who are beginning to see ILS, cat bonds and alternative reinsurance capital as a threat, but as we noted in another article others, such as insurers, may look to leverage the reduced cost of risk transfer for their own benefits and the trend towards more cost-effective, capital markets backed risk transfer could create a more substantial change in the re/insurance markets.

Of particular note in the report is Lane Financial’s own synthetic index of ILS and catastrophe bond rates-on-line, which has reached a recent low of 123.4. The report notes however that this doesn’t include the recent closing of the Everglades Re 2013 cat bond, which saw a big reduction in pricing on the deal a year earlier, despite having a higher expected loss. This suggests that another calculation of the rate-on-line index to include Everglades Re could reduce the number even further.

The report highlights another interesting fact about the Everglades Re deal which we noticed in recent secondary cat bond pricing. Just one day after the cat bond closed the first quoted secondary market price on the deal was above par at 102.07, showing that even investors felt that there was value to be had in bidding above the launch price for this cat bond.

As ever Lane Financial are insightful on capital trends in the market and it believes that we’re beginning to see more ‘sticky’ capital enter the reinsurance and ILS space from sources such as pension funds. Pension funds take a notoriously long time to perform due diligence on a new asset class and tend to have a long-term investment view.

Lane Financial put this across in a really nice way, describing it as “Slow to be seduced to a commitment; slow to pursue a divorce”. This is a very accurate portrayal of this type of capital that we’re beginning to see move into the ILS market in a more meaningful way. It is stickier, it does have a longer-term view and it has done considerable, sometimes years of, due diligence before allocating to the sector. As more of this capital comes online in the ILS and reinsurance-linked investment space, the old paradigm of capital being quick to leave the sector after a loss may not be so true anymore.

As Lane Financial note, if the paragraph above is correct the excess capital situation in the reinsurance market could be with us for sometime. It really could become a ‘new normal‘ and it’s probably more accurate to describe this as ‘slow capital’ rather than fast.

So, with the above in mind, continuing inflows of capital a lot of which appears to be more sticky, excess capital in the reinsurance space and already softening prices, Lane Financial say that absent new catastrophe events premiums appear to be heading down even further.

The market is not as soft as it’s ever been, the charts in Lane Financial’s report evidence that fact, it has some way to go before getting back to historical low levels. However it does seem to be on its way down and it’s worth considering that this time around there is a new dynamic in the room, $35 billion+ of capital from third-party sources which will be available as reinsurance capacity to those who require it.

Lane Financial note that the capital markets were not a viable alternative in the soft markets of the 1990’s, in fact it wasn’t anywhere near as big in the soft markets before 2008. Lane Financial muse that perhaps a soft market could result in more capital markets issuance of ILS and cat bonds, and use of collateralized sources of reinsurance capacity, than less.

The report then takes a look at the tail risk of the ILS and cat bond market, which it suggests is largely dominated by U.S. hurricane risk. The analysis shows that there is really not much diversification beyond U.S. wind risk in the tail of the market, an issue which does worry some ILS fund managers currently who would love to see more opportunities for diversification come to market. Perhaps these soft market conditions might enable or encourage more issuance of diversifying perils, that would certainly be welcomed.

Comparing a portfolio of ILS and catastrophe bonds as of the end of Q1 2013 with its equivalent pre-Tohoku (when the market was soft) and also a year earlier in 2012 (when the market was hard) demonstrates the way the market has begun to soften. The weighted average yield in the secondary market in 2011 was 5.11%, in 2012 was 8.51% and in 2013 is 6.63%. The weighted average expected loss in 2011 was 1.95%, in 2012 was 2.09% and in 2013 was 1.91%. This leads onto the market multiple, or the relationship between yield and expected loss, which in 2011 was 2.6, in 2012 was 4.1 and in 2013 was 3.5.

The above numbers show how the market hardened at the start of 2012 quite significantly, as was evidenced in the secondary cat bond indices at the time. It has since softened but not yet enough to get back to the pre-Tohoku levels.

One interesting metric Lane Financial discuss is the 1 in 250 year modelled loss of the portfolio of ILS it studied for the report, versus previous years. This figure is higher in 2013 than either of the two years earlier, sitting at 56.61% now, versus 48.11% in 2012 and 35.92% in 2011. Lane Financial speculate that this could be to do with the lack of diversification in the ILS markets tail, and note that this could have implications for expected returns to catastrophe companies. Looking at the expected profit, or return, on a 1 in 250 portfolio the number is lower in 2013 than in the hard market of 2012 or the softer 2011, this suggests a lower return for investors at this time.

Finally of note for this piece on the Lane Financial report is the weighted average price of secondary cat bonds in the portfolio, which it puts at 103.67. This is evidence of the market working as expected, as in a soft market bonds should price above par. However, again that premium is higher than when the market was actually softer in 2011, when it was 101.96.

Lane Financial conclude that the reason we are seeing key ILS market indicators at more extreme levels than in earlier, and softer, market conditions in 2011 is that the current soft market has been much quicker to emerge than it was in 2011. They close by stating that this also suggests that capital has been devoted to the market in a rush, insinuating that this could have been a factor helping to bring on a softer market.

Those ideas from Lane Financial make a lot of sense when you consider how the cat bond and ILS market has reacted so far in 2013, with capital inflows remaining high, then lower primary issuance causing unseasonal price gains in the secondary market, followed by price reductions when new issuance returned. Whether the trend will continue and the market will continue to soften is difficult to forecast, but it seems likely that absent any major catastrophes or loss events we will see ILS and cat bond pricing remain at low or softening levels.

Excellent analysis from Lane Financial as usual. The report also contains detailed charts on the market at the end of Q1 2013. We’ll likely cover a few of those key charts next week, but in the meantime for your weekend reading we recommend you go and register on the Lane Financial website and download a copy of the full report.