ILS continues to mature

2017 was the year that insurance-linked securities (ILS) truly came of age. Born in the aftermath of Hurricane Andrew in 1992, and maturing in the wake of Hurricane Katrina in 2005, the market celebrated its 25th birthday by showing that it worked; that it could provide the protection that insurers need when faced with significant losses from a series of natural disasters.

2019 has shown that ILS can not only protect insurers and reinsurers—it can also provide a solid and diverse investment opportunity to pension funds and other capital sources even when losses occur. While a few investors have shown concern about participation in a market where losses are real and capital can be trapped, more have seen how the market operates and realised that it is and will remain a valuable diversification for their funds.

There will be further growth in the sector in 2020. Insurers and reinsurers, along with their regulators, understand the need for collateralised protection against industry-threatening losses. The industry must be protected against events like, or even larger than, Katrina, and individual insurers or reinsurers need protection against more localised events.

As the reinsurance market has consolidated and as the need for retrocession has increased, reinsurers are increasingly looking to capital sources outside the circle of their competitors. It has always been a paradox of retrocession that rival companies support and work closely with their competitors.

Now that the number of reinsurers capable of providing the amount of capital protection that other reinsurers require, this paradox becomes an obstacle; an obstacle that is overcome by the use of alternative capital sources.

Diversification needs

The demand for ILS products from reinsurers does, however, create issues of its own. 2017 showed that too much exposure rests in windstorm risks from the Gulf of Mexico. The market needs diversification of risk.

There are, however, problems with creating diversification of risk. Many areas of the world, in which insurance markets are strong and mature, simply do not have exposure to natural catastrophes or, if they do, have government-backed solutions to them.

The UK, for example, has one of the highest insurance penetrations in the world but is not exposed to many of the natural perils which are the mainstay of the ILS market, such as earthquakes, hurricanes or tsunamis. The one major natural peril, flood, is covered by the government-backed Flood Re.

Other areas of the world, particularly in the developing economies, have perils but not insurance penetration, so ILS products would not impact hugely on the risks that arise from those countries should they focus solely on protection of insurers and reinsurers.

There is, however, a growing movement towards the utilisation of ILS products, particularly cat bonds, to protect not insurers but governments. In 2020 there will be an increase in activity in the area of sovereign catastrophe risk and in the next decade there could well be the development of a significant market in the area, giving protection to developing countries and diverse investment opportunities for funds.

Geographic diversity is not the only way to reduce dependence on Gulf windstorm perils. There is significant activity in other areas of risk, chief among these cyber, with a number of entities exploring ways to protect insurers and reinsurers against the potentially massive losses that could arise from an accumulation of cyber attacks.

In a similar vein, some people are looking increasingly at the liability market as an alternative source of risk. While the scale of the problem is all too apparent, with projected losses from the opioid epidemic alone forecast to exceed $50 billion, the means whereby ILS can help to solve that problem while creating opportunities for profit remain elusive.

2019 has been a good year for ILS; 2020 could be a great and exciting year.