As the casualty insurance-linked securities (ILS) market continues to expand, rating agency AM Best has indicated that market participants will need to remain focused on ensuring that both underwriting discipline and risk transparency develop simultaneously in order to keep pace with investor demand.
While innovation in the capital markets can offer significant sources of capacity, AM Best has pointed out that some reinsurers have raised concerns about the speed and framework of specific casualty insurance-linked securities initiatives.
In a recent report, AM Best notes that casualty ILS remains a relatively small portion of the overall alternative capital market.
“The limited penetration of alternative capital into casualty risks is noteworthy given that industry observers have discussed the possibility for more than a decade. While ILS successfully transformed portions of the property catastrophe market, many of the characteristics that made catastrophe risks attractive to investors—including low correlation to capital market returns, shorter investment duration, event driven loss emergence, and relatively transparent modeling assumptions—have proven far more difficult to replicate within casualty business,” the agency explained.
Nevertheless, while investor interest towards casualty-linked structures continues to grow, AM Best importantly emphasises that the market remains “substantially smaller than many earlier projections envisioned.”
“Whether recent innovations can overcome those historical limitations remains one of the more closely watched developments within the broader convergence market,” AM Best said.
Adding: “While innovation within capital markets can provide valuable sources of capacity, some reinsurers have expressed concerns regarding the pace and structure of certain casualty ILS initiatives.”
The agency indicates that the concern is primarily two-fold, focusing on the concept itself and whether all participants have a comprehensive understanding of the risks being transferred.
It is also important to remember that casualty liabilities can take years to emerge and are influenced by evolving legal and social environments, as well as capital market volatility.
This can ultimately lead to significant uncertainty regarding the eventual loss development and the returns on the float that seem appealing to investors.
In addition, AM Best emphasised that, in contrast to many catastrophe exposures, the underwriting risks linked to casualty business may not become fully evident for prolonged periods. They agency notes that numerous traditional reinsurers contend that this uncertainty is inconsistent with the overarching premise of ILS.
As well as this, the agency also flagged how a number of industry participants have showcased the potential for elevated investment risk within certain proposed structures.
Furthermore, the report also explains that there are concerns regarding how investors may choose to predominantly concentrate on attractive yield opportunities, without fully understanding the complexities of the underlying liabilities and the significant effect that the timing of those liability payments can have on overall returns.
AM Best’s report acknowledges that this has been evident in recent years within the private credit markets, as early redemptions have reportedly caused devaluations in times of liquidity needs.
The agency importantly states that these concerns do not apply universally to the entire casualty ILS market.
“Many casualty ILS structures are being developed thoughtfully and involve sophisticated participants with substantial expertise utilizing conservative investment allocations. However, the industry’s experience has demonstrated that isolated examples of poorly structured transactions can sometimes influence perceptions of an entire asset class,” AM Best added.
Concluding: “As casualty ILS continues to evolve, market participants will likely remain focused on ensuring that underwriting discipline and risk transparency develop concurrently with investor demand.”
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