Hurricanes will push ILS market to the next stage of evolution

Despite the losses in the ILS market, the recent storms have alerted a number of new investors to the existence of ILS as an asset class and sparked interest at a time when rates are likely to increase.

Insurance-linked securities (ILS) are at a crossroads. The next few months will show whether, as some in the market have foretold for years, ILS was a fad that would not survive its rst major test – or whether, as others have said, it has become a core part of the future of risk transfer.

There are those who look at the recent hurricanes and the losses they will cause to ILS investors and predict many of those investors will abandon ILS as an investment class. The theory is the pensions funds and other capital market players who sought high-yield returns in a diverse investment class were not prepared for losses, having enjoyed almost a dozen years of benign hurricane activity.

Such a view does not exist solely in the traditional reinsurance market. Indeed, in one of the few references to cat bonds in the popular press, the Daily Mail recently described them as “toxic” investments.

This view ignores the sophistication of ILS investors and those who manage their investments.

Like insurance, ILS has a purpose and that purpose is to protect purchasers of its products against losses. Without losses, there is little point to ILS. The recent hurricanes have shown ILS can be extremely useful in protecting insurers and reinsurers from major losses and can ensure their solvency remains robust.

ILS rst emerged as a concept after hurricane Andrew in 1992. That Florida hurricane and the subsequent storm, Iniki, that hit Hawaii, imperiled well-established insurers that had signicant market share in the affected states. Capacity in the insurance and reinsurance markets was short and ILS was developed as a way to provide protection from future capital events.

That said, for the first 13 years of ILS, more speeches, articles, seminars and conferences were devoted to ILS than deals actually done. It was not until the next major capital event in the market in 2005, when Katrina, Rita and Wilma hit the Gulf coast, that ILS activity increased to the level it is at today.

Before that time, some investment in ILS may have been more opportunistic. Since then and the global nancial crisis of 2008, it has become more strategic. Sophisticated investors have looked not only for diversication into ILS but also diversication within it.

 

While Harvey, Irma and Maria may have caused some investors signicant losses, in many cases they will be compensated by other protable participations in ILS deals.

Perhaps the biggest challenge investors face is the issue of trapped funds. Insurance Day reported recently that up to $12.5bn may be trapped. This is likely to be signicantly greater than the ultimate sum that will be paid out to the protected entities.

In some cases with indemnity triggers, the contracts call for sums to be withheld when reserves reach around 50% of the trigger amount. This can trap funds, which will never be called on, for a lengthy period. This will cause problems for investors who have a notoriously short-term view. Indeed, some enterprising investors, with longer-range investment appetites, are offering to fund the release in return for a generous premium.

This is one issue that may deter some investors. For every investor that is deterred, however, there may be many more willing to enter into the market. The recent storms have alerted a number of investors of the existence of the asset class and sparked interest at a time when rates are likely to increase.

Solvency

It is not only fresh investors who may be attracted to ILS. The job that ILS has performed in protecting the insurance and reinsurance market from the impact of the otherwise devastating storms has been impressive.

Put simply, the market has just weathered the biggest economic loss in history without any question being raised as to the solvency of a single insurer. ILS has done what it was designed to do and, in doing so, has shown it can protect not only insurers and reinsurers with exposure to the Gulf of Mexico but can also protect them against other perils.

Where ILS was born after Andrew and grew up with Katrina, Irma could be the storm that sees it reach maturity. Providing protection against a wider range of natural catastrophes and, potentially, other risks would provide insurers and their regulators around the world with the comfort of knowing companies can manage whatever losses may be thrown at them from whatever cause. Expansion of ILS in this way would also add to the diversity of risk available to investors.

Of course, the issue of trapped funds remains and requires consideration. One solution that may work well in other areas of the world or in other risk classes is the adoption of parametric triggers. Parametric triggers allow for swifter determination of the amount of loss and therefore less need for trapping unneeded funds. Parametric triggers are also more useful in classes of business where indemnity data is sparse but objective meteorological or other extrinsic information is readily available for modelling.

Harvey, Irma and Maria do not represent the end of ILS but, more likely, a strong new stage in its development.

This article was produced by Clive O’Connell and first published in Insurance Day.