Spread compression possible as ILS investors have capital to deploy: Aon

Aon Benfield has predicted that sponsors and investors will return to the catastrophe bond & insurance-linked securities (ILS) space in the closing months of 2016, but with investor demand potentially outweighing supply, further spread compression is possible.

Aon Benfield, the reinsurance arm of brokerage Aon, expects an active end to the year for the catastrophe bond and ILS space, but does warn that further spread compression is possible, with investors remaining attracted to the space and the supply of new deals potentially failing to keep pace.

In its September 2016 ILS market report, Alternative Markets Find Growth Through Innovation, the reinsurance broker highlights that Q3 is typically a quiet period for the ILS space, but stressed that it expects sponsors to return to the market in the second-half of 2016.

In fact, as shown by the Artemis Deal Directory and discussed in the Artemis Q3 2016 Catastrophe Bond & ILS Market Report, the third-quarter of 2016 was actually one of the only Q3s in the market’s history that saw issuance surpass $1 billion, so investor and sponsor appetite was evident.

“Many investors have capital to deploy, which may lead to further spread compression. Demand for bonds that diversify investors’ ILS portfolios by providing exposure to alternative perils, such as casualty and non-US perils, will continue to grow. Overall, we believe the market will continue to be attractive for sponsors that choose to incorporate alternative capital,” said Aon Benfield.

Alternative reinsurance capital continues to grow in size and is increasingly looking to access business outside of the highly competitive property catastrophe space, where returns are compressed and expected to fall further as the softening landscape persists.

Aon Securities reported recently that the ILS market had grown by 10% in a year to reach a reported $75.1 billion and, Artemis also discussed how larger ILS fund managers were also actively raising capital, so clearly there is an abundance of available and willing capital market’s investor-backed capital looking to be deployed in the ILS market.

Institutional investors appear willing and remain interested and attracted to the ILS space. While returns in the sector might not be what they were previously owing to broader re/insurance market pressures, the diversifying, uncorrelated and stable yields on offer make it a very attractive alternative asset class for large institutional investors, especially when compared with other alternatives.

However, with conditions in the current marketplace perhaps being more favourable to the collateralised reinsurance structure over the catastrophe bond, something highlighted by Chief Executive Officer (CEO) of Aon Securities, Paul Schultz, investor demand for cat bonds might not be met with adequate supply, which could lead to further spread compression.

Investors in the space are expected to deploy capital in the final months of the year, and while an above average volume of issuance, in terms of the number of deals was recorded in Q3, it remains to be seen how active the market will be in the final months of the year and whether sponsors can meet investor demand, or whether other ILS structures might be more suited, at this point in the cycle.

Investors appear willing to take on a lower yield in return for a diversifying, uncorrelated investment that typically only makes up a small portion of their overall investment portfolio.

So should the supply of new issuance fail to meet the demand from investors for insurance and reinsurance-linked risks, market conditions remain challenging, and investors having capital to deploy, further spread compression could well be on the horizon for the cat bond space as it moves further into the fourth-quarter.

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