ILS: Breaking new ground
The insurance-linked securities (ILS) market continues to grow in assets under management (AUM) and influence, in part by diversifying in product form. This growth and diversification adds some complexity and nuance to a market that was originally more limited in scope. As such it may be helpful to change how to follow the market going forward.
That does not mean disregarding the old metrics entirely but simply supplementing those metrics with new ones. This is similar to how the many ways we now consume media have complicated things for advertisers. Broadcast TV ratings still matter, but viewing rates for cable as well as downloads of top shows matter too.
What is the size of the ILS market?
When measuring the size of the market the simplistic view is to focus on three numbers: ILS AUM, annual cat bond issuance and amount of cat bonds outstanding. ILS AUM grew in 2016 to $75 billion. In the past, it was clear what that meant. Investors had relatively little leverage.
With the presence of leverage in its various forms, $75 billion in AUM no longer means $75 billion in limit. Many sidecar arrangements cap the supported limit at a modelled return period (eg, 250 years). Sidecar and reinsurance premiums provide additional leverage, as do excess of loss fronting arrangements. Ideally we need to filter the AUM growth metric by leverage and by product form to better understand the changing impact of ILS.
Our 2017 baseline is that we expect AUM to grow at a similar pace as it did in 2016. Nonetheless, leverage will grow more rapidly as investors use fronting and similar techniques to enter insurance and reinsurance. This could mean more capacity and more competition even if AUM grows more modestly.
Similarly, cat bond issuance and outstanding cat bond capacity no longer tell the story of market success as a whole. Instead, these figures remain the most transparent piece of the overall ILS market. They speak to the depth and breadth of the ILS investor base. Cat bond market share grows when players who require more liquidity become more prominent. Many of the more established players are happy to trade illiquidity for higher rates and less competition. In contrast, a minority of the established investors as well as investors newer to the sector favour the liquidity and transparency of the cat bond product.
Our baseline is that cat bond issuance will increase, fuelled by both pre-existing demand from investors for more liquidity and a further by wave of maturities in early 2017. This year could see $6 billion to $7 billion in new nonlife cat bond deals or perhaps even more.
It is still too early to say that this trend toward cat bond issuance growth is more than cyclical.
Why? Recently, the established players seem to be winning. Most of the AUM growth is new assets for old players rather than for truly new players. The short-term trend toward relatively more cat bonds could become more permanent if we see the balance tilt back towards more new entrants in the ILS investor arena.
What perils does the ILS market handle?
Traditionally, ILS peril distributions are based on cat bonds alone. This remains a serviceable proxy for the overall market although leverage creates some real distortion. As with rated reinsurers, ILS investors enjoy maximum leverage for perils that are not peak perils.
If investors need leverage to be more competitive with a specific peril, fewer diversifying cat bonds will occur relative to ILS investments with more accessible leverage. As such, nonpeak perils are actually more prominent than the cat bond figures would suggest. A second order distortion is that outside of the peak zones, unmodelled perils take on increasing importance resulting in additional understatement of portfolio risk derived from nonpeak perils.
Our take is that peril diversification will continue in 2017 at a modest pace. Investors are looking to take on more risks if it means becoming more relevant to ceding companies. In doing so they need to achieve appropriate economics and couple that with a good understanding of risks. Goodwill cannot overcome bad maths. Transparency, alignment, and simplification, however, can help ILS investors participate along with experienced underwriters outside the traditional well modelled property cat space.
Pricing and convergence
To the extent that ILS-supported limit rises more rapidly than limit in the market as a whole—our expectation for 2017—it will tend to put downward pressure on risk spreads and corresponding risk margins (risk spreads minus expected loss) across the many different ILS products. All else being equal, this decline in margins also puts downward pressure on end investor returns (eg, the returns to ILS fund investors.) In the current situation, rising rates on US dollar ILS collateral tend to counteract the decline in risk spreads as long as the rising yields do not represent increased credit risk to any great extent.
