Swiss Re ILS deal maps the future of ILS: Lohmann

Swiss Re’s recent innovative ILS deal, completed with JP Morgan and designed to help the reinsurer manage its capital, has the potential to grow the sector exponentially, says one of the industry’s pioneers Dirk Lohmann, speaking ahead of the conference Re/insurance Outlook Europe, being held in Zurich in June.

New types of ILS deals designed to help re/insurers manage capital, such as Swiss Re’s innovative multi-year stop-loss transaction completed with JP Morgan, have the potential to expand the potential universe of ILS into new territory—and potential strong growth.

That is according to Dirk Lohmann (pictured), chairman, Schroders Capital ILS, speaking just months after Swiss Re closed its second deal of this nature—$700 million protection against severe underwriting losses, again structured as a multi-year stop-loss deal in partnership with JP Morgan, which uses a combination of bank financing and insurance-linked securities (ILS).

Swiss Re said the deal, which protects it through the years of 2023–2027, will allow it to grow its business in what it called favourable market conditions. Issued using special purpose vehicle Matterhorn Re, Swiss Re added that it will have a positive impact on its regulatory and ratings capital requirements.

This is one of the things likely to be discussed in a special session at the Zurich event titled “Unlock capital via third parties to find solutions for new and existing risks”. A panel of experts, including Lohmann, will analyse recent levels of returns by reinsurers and investors versus expectations, debate the impact on capital caused by inflation, climate change and an increasing demand for insurance products and debate recent changes in capital regulations and requirements such as IFRS17.

Lohmann described the transactions as innovative in their nature because they are focused largely on managing capital. If the use of ILS instruments can play an important role in the capital structure of re/insurers, the potential growth for the ILS markets is enormous, he said.

“This is an area that could have a lot of potential for growth in the industry. Reinsurance, whether it’s catastrophe reinsurance or other forms of reinsurance, is a capital surrogate. What I like about these transactions is that they’re focused on the remote end of the capital spectrum with regard to solvency requirements. People are looking at developing structures which are attractive for ILS investors—they give more remote tail risk, but not only in a catastrophe form.

“That expands the potential universe of issuance. There’s only so much cat reinsurance any company needs to buy, and some of that is more effectively transferred using traditional reinsurance. The ILS market is at roughly $40 billion. Maybe we can double that. But the total capital of the industry is maybe $600 billion. The question is, therefore, can we, the ILS sector, become a key component of the capital structure.”

Of recent innovations Lohmann has seen in the ILS sector, this is the most significant—because of its potential size, he says. But there have been others. He notes that two recent ILS deals that transferred cyber risk into the capital markets were significant, although he adds that cyber remains an emerging asset class. “It will take time to become mainstream.”

He cites innovation in the way some of the underlying assets in ILS deals are becoming greener and more sustainable as they are being invested in green qualifying securities. He says this is helpful for funds trying to fulfil certain ESG criteria, often under the EU Sustainable Finance Disclosure Regulations (SFDR). “We’re seeing a clear recognition among sponsors in North American of the importance of better disclosure with regards to ESG. They recognise that this is important for investors in Europe, which represent the largest potential buyers of their issuance.”

Commenting on wider investor sentiment, Lohmann says there has been some tightening of spreads this year as investor demand has started to increase. But he stresses that it very much depends on the deal and underlying risk. “If you’re Florida only, I don’t see much tightening at all. If you’re a diversifying risk from Florida, then you may see increased interest and tighter spreads. Having said that, spreads remain at multiples of what they were one or two years ago.

“There seems to be a little more liquidity in the market and we are observing increased interest among potential investors. Some of these may have invested in the space previously and withdrawn. Now they are seeing spreads that are quite wide and, given the volatility in more traditional assets, they see this as an opportunity to reconsider. It hasn’t been a flood of interest. There remain certain reservations about the asset class. The bias is towards the more liquid strategies.”

On the other side of this coin, he admits that some sponsors have come under pressure as, in some cases, their ILS placement has been more expensive than traditional coverage. But he adds that most value the strategic options the market gives them for the long term. “Some may have been challenged internally because the cost of cat bonds was maybe higher than traditional reinsurance.

“But things come and go quite quickly. Long-term sponsors have been able to successfully issue in the market again and again and they get more favourable treatment because the investors know that these sponsors have made a strategic decision to access this capital.”

Against this backdrop, Lohmann believes the hard market could endure for “a good while”. He suggests that the earnings of re/insurers remain under pressure due to a mixture of attritional losses and inflation.

“They’re trying to keep up with inflation by increasing their rates but I’m not sure whether they’re ahead or behind in that race. As a consequence, the earnings have not materially improved. And as long as they’re under that stress, capital isn’t going to flow into the industry and they’re going to need alternative forms of capital. That bodes well for our ILS business, as a supplier of capital.”

He believes this situation will persist through 2023, his caveat being what the North Atlantic Hurricane season will bring. “If cat losses occur within budgets it is OK. The real problem is attritional losses and inflation. And the question is, how can one manage that and still move towards an improved earnings?”

Lohmann will be discussing some of these themes in more detail at Re/insurance Outlook Europe, being held in Zurich in June.