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The 2008 global financial market crisis was a turning point for the ILS industry. Initially it resulted in a sweeping cut to capacity as investors used ILS funds like ATMs to withdraw cash.
But over the long term, the crisis drove more investors into adopting a sector that had shown its diversification power by holding its value as mortgage-backed securities and other structured finance deals plummeted in value.
Fast forward 12 years and the markets are again being roiled by events that we thought had been consigned to the history books.
Will this crisis be another turning point for the industry – and can it turn the situation to its advantage again?
In some ways, this crisis looks to have been much smoother sailing for the ILS sector, but in others the pandemic has stirred up difficult undercurrents. IQ looks at how the alternative reinsurance market has navigated the coronavirus challenge so far.
Calm after the storm
As the pandemic’s spread became apparent in March and as countries began locking down their borders and streets, an initial panic hit the markets as investors fled to the security of cash.
This “flight to cash” showed up to some extent on the liquid side of the ILS market – the cat bond sector – although the impact on pricing was subdued compared with the kind of writedowns being recorded in traditional markets.
As sister publication Trading Risk reported at the time, around $400mn of cat bond holdings were offered in bulk auctions on the secondary market in March. This was said to be largely driven by multi-strategy fund investors facing cash calls from their management, or demands from retail investors to cash out.
However, the resulting price hit to the outstanding bond market was 1.09 percent in the steepest loss week from 20 to 27 March. And in the first quarter, ILS returns remained positive while other benchmarks experienced losses of up to 20 percent (see chart).
And in terms of the demands on liquidity at the specialist ILS managers, the experience was much more manageable than the “ATM effect” they had suffered back in 2008.
Fermat Capital co-founder John Seo recalled that, back then, the US cat bond specialist had to sell off a quarter of its assets to meet redemptions, but only had to sell off around 2 percent in the worst month this time around.
Meanwhile, another leading ILS pioneer, Nephila Capital, also testified to the relatively modest impact on its capacity in the first half of 2020. Co-CEO Greg Hagood said the $10.4bn firm expected a 7 percent drop in its asset base after receiving $400mn of last-minute Covid-related redemptions in late March.
Though the Covid-related shrinkage compounded a year of retractions for ILS capacity as a whole, following the major loss years of 2017-2018, the direct impact was minor compared to the scale of investment markdowns at rated carriers.
Steadier hands at the tiller
Why has the ILS industry responded so differently and avoided the ATM effect this time around?
Hudson Structured Capital Management (HSCM) co-founder Michael Millette argues that the shift in the ILS investor base since 2008 has been one decisive factor in the differing reactions.
Back in 2008, more of the market was supported by funds of funds investors and hedge funds seeking the higher-return strategies that were available at that time. But after that crisis, those investors did not return in the same way and were replaced with more institutional investors and pension funds, which saw the sector as a long-term bet (see chart).
Institutional investors that now back ILS managers have made strategic allocations to the sector to diversify and are unlikely to “bolt fast”, Millette remarked earlier this year.
However, most pension funds will not face an immediate pressure to realise cash and could find the diversification provided by ILS reassuring.
“The terrifying correlation of every other market on earth that we witnessed unfold quickly as the virus spread is a lesson that allocators won’t forget,” Millette said.
Meanwhile, the fact that the ILS market held value throughout the initial crisis will be used as further proof of its non-correlating or diversifying performance, and could lay the grounds for future growth to help rebuild from the losses of 2017-2018.
Charting a new course
However, there are still choppy waters ahead for the ILS market – and the first challenge is proving that it can steer clear of the threat of pandemic-related business interruption (BI) claims.
The main exposure here is from commercial property insurance and reinsurance risks, since there is little ILS participation in event cancellation, trade credit, workers’ compensation or any of the other lines of business that are expected to take a hit from Covid-19 claims.
The BI issue has a far-reaching scope, beyond the ILS market’s involvement. Underwriting companies have insisted that their policies do not cover the systemic threat of viral pandemics, but business owners struggling to make it through lockdowns have taken cases to the courts, where the industry is anxiously awaiting the outcome of the first set of precedent cases.
If judges rule against insurers and unleash a torrent of claims, many fear that losses from this unmodelled, highly correlated peril could push investors out of the ILS market as the unexpected loss follows back-to-back losses in 2017 and 2018, including significant model miss events.
However, other experts emphasise that the huge Covid-19 insured loss numbers being projected by some in the market incorporate large claims from segments with no ILS involvement at all.
HSCM’s Millette suggested during a recent Trading Risk webinar that trade credit losses could represent around $20bn, with a further $10bn-$15bn from liability lines, $10bn from the contingency market, and additional workers’ compensation losses.
“Those numbers are not really part of the capital market segment of reinsurance,” he pointed out. “For the sector to see losses creep up into cat towers, we would have to see a thoroughgoing judicial refutation of language, which I do not expect.”
In the US, many property insurance policies have standard ISO wordings including virus exclusions alongside physical damage requirements to trigger BI losses.
“This [wording] isn’t as dubious as some lawyers would want you to believe,” said Millette.
Certain segments of the ILS market are better reinforced than others against BI claims “leakage”, as it is known in industry jargon. Cat bonds, for example, employ named peril coverages rather than all-peril language, and most also cover residential exposures rather than commercial lines.
Rebuilding and repricing
Regardless of the ultimate level of Covid-19 losses, the ILS industry will undoubtedly see further change and evolution in the wake of the pandemic.
After all, even if claims are overturned, there could be disruption from trapped capital if cedants are able to lock collateral at the end of a contract while they allow time for losses to evolve. This is a source of frustration for investors as in some segments, such as retro, this will be the fourth year impacted by some degree of trapped capital.
This “investor fatigue” as a result of trapped capital is also matched by caution from cedants dealing with a long-tailed catastrophe event, wary of whether property BI losses could pop up in future years after they have released ILS reinsurance capital.
Taken in tandem, these issues are likely to drive further evolution in the ILS market’s use of rated paper, whether from fronting providers or in-house, as well as contract negotiations on commutation and clawback terms.
Terms and conditions are also increasingly under the spotlight in the ILS and broader markets as underwriters seek to capitalise on the hardening market to tighten up coverage. Within the alternative reinsurance sector, it remains to be seen how far underwriters will move towards use of named perils beyond the cat bond space – with sources suggesting this shift is occurring in retro as well.
For reinsurers and ILS writers, one positive side-effect of the concern over pandemic losses is that it has amplified property catastrophe rate increases – a trend which was particularly evident at the Florida June renewals.
Capital has already started flowing back in to the market, with $4bn to $5bn raised through major equity issuances from Bermuda and London players such as RenaissanceRe, Fidelis and Lancashire.
New start-ups are also on the horizon – but while there are some signs of green shoots in the ILS market as well, the industry has had little success in mid-year fundraising overall.
A major obstacle has been the difficulty in bringing on new investors without being able to do in-person due diligence – while existing investors are also distracted by more immediate opportunistic plays elsewhere.
But with rate momentum building, the ILS sector will be pushing the potential growth story out to investors ahead of the next major pre-January fundraising round.
And just as it is expected to take months and years for (re)insurers to get a clear grasp on their Covid-19 losses, so too it will take time to understand how the ILS market will be changed and reshaped by the pandemic.