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ILS Achieves Dynamic Equilibrium: ILS Market Update Q3 2019

Insurance Consulting and Technology|Insurance Linked Securities|Reinsurance|Investments
Insurer Solutions

November 1, 2019

Going into Q4 and with 2020 just around the corner, the insurance linked securities (ILS) market is in dynamic equilibrium and positioned well.

Alternative capital in all different forms is clearly growing again, notwithstanding the losses and related loss creep of the last several years. This is not a rising tide raising all ships. Far from it - some managers, sectors, and strategies outperformed the past few years and are benefitting now as a result. Others remain under some stress. For example, capacity remains restricted for ultimate net loss (UNL) retrocession with only limited interest so far from new investors. Along with reduced loss creep, the higher premiums and the associated improved risk/return profile have provided a tailwind.

Short-term outlook

Concretely, starting in Q4, but with more effect in 2020, we expect growth in the more liquid forms of ILS. In addition, some investors are realigning their portfolios toward more risk remote investments. The turn toward seeing increasing relative value at the more remote end could potentially bode well for cat bonds within the more liquid ILS space. Sidecar interest has picked up as well; however, the extent to which this interest will translate into completed deals will depend very much on the specific opportunities presented to investors, as not all deals will meet investor criteria.

In addition to the surface market dynamics, we have identified two other trends to watch, one subtle and one headline grabbing that may impact the near term.

Regulatory change: a trend to watch

First, on the subtle side, choice of legal entity and domicile is not usually near the top of the list of key factors influencing ILS market activity, but this year could be different. There is an unusual amount of innovation and change in this area around the world. The change creates interesting options for market participants.

Guernsey explicitly permits collateral gaps

One important trend to watch in this area is the impact of the changing collateralized reinsurance regulations in Guernsey. Guernsey has invented a new type of cover, where sophisticated parties can agree contractually to up to a 30-day gap in collateral to accommodate, for example, rollovers between years. You might call this “uncollateralized collateralized re.”

One important trend to watch in this area is the impact of the changing collateralized reinsurance regulations in Guernsey.

It is undoubtedly favorable for investors — as collateral providers can promise the same collateral twice. Whether cedants (or their regulators) will use this option remains to be seen. This approved practice effectively acknowledges the status quo, a not very well-kept secret that much collateralized reinsurance activity is not actually fully funded at all times.

Activity elsewhere

Guernsey is not alone in moving forward. The U.K. and Bermuda seem to be moving firmly the other way from Guernsey to make sure collateralized reinsurance is always fully funded (as required by Solvency 2, for example), or where gaps exist, the gap is bridged by a financial guaranty or similar mechanism. Specifically, the U.K. is fine-tuning their ILS rules based on several years’ experience, and Bermuda has taken a more substantial step, creating a new class of hybrid entity providing a cross between a special purpose collateralized insurer and a regulated and rated entity. At the same time, Bermuda is tightening up enforcement of its existing rules for Special Purpose Insurers (SPIs), so SPIs are used as originally intended.

The U.K. and Bermuda seem to be moving firmly the other way from Guernsey to make sure collateralized reinsurance is always fully funded or where gaps exist, the gap is bridged by a financial guaranty or similar mechanism.

To the extent the U.K. and Bermuda approach becomes the new status quo for collateralized reinsurance, it will put all deals on essentially equal footing and better protect cedants. Better protection will mean that collateralized vehicle performance and cedants’ expectations will nearly always line up, which was not true in the past few years in a small number of cases. On the other hand, it will reduce investor leverage as they will be prevented from using the same capital twice and need to price for this additional cost.

Beyond the U.K. and Bermuda, Singapore, France, and other places are also moving forward with new initiatives. Singapore’s grant scheme has, thus far, achieved some modest success with at least three ILS deals of various forms completed. Singapore has a sophisticated financial sector coupled with a vibrant regional reinsurance hub offering a natural home for ILS activity. France also has opportunities in the ILS space, and not just because of Brexit, as evidenced by the completed 157 Re deal earlier this year. It also has local lawyers, administrators and regulators with the proper skill set to support sophisticated ILS activity, if they can achieve a reasonable scale.

New risks and cedants: another trend to watch

A second trend to watch is market participants’ hunger to discover and transfer new risks. This hunger comes from a desire to see and accomplish something new, from a concrete desire to satisfy an unmet need such as closing the disaster gap or helping pensioners and retirees further diversify their investment risks, and sometimes solely from compelling economics for both sides of a new type of trade.

Consistent with Michael Bennett’s interview, there is a growing awareness that governments and related institutions can play an important part in facilitating risk transfer, especially to ILS investors, where private markets fail to do so on their own.

Historically, much of this optimism was wishful thinking ungrounded in actual economics – pie in the sky, if you will. At present, though, the optimism around new risks and cedants seems relatively more justified. This is not only because of the role of institutions like DFID and the World Bank, but also because the economics themselves are getting better.

The reasons for improvement include the rise of a new source of capital from ESG and Impact investors. This is really an emerging trend in 2019. We are also seeing better risk modeling and valuation approaches building on both scientific advancement and lessons learned from recent loss and reserving history.

We also see a growing appreciation of the benefits of risk transfer by cedants, especially countries, coupled with the constraints of the traditional (re)insurance capital structure to efficiently solve really big problems (e.g., tail aggregations of terror or cyber risk) without ILS capital partnerships. None of these new risks can overcome flawed economics to come to the market but they can close the gap quite effectively when the gap is not large.

The promise of ILS to policyholders is to indirectly make insurance more available and affordable in conjunction with the broader industry. We are at an inflection point, where ILS is once again poised to grow and support this objective.

This figure is displaying the results of non-life insurance-linked securities issuance by quarter from 2014 to 2019. Quarter 1 2019 totaled $1.1 billion and Quarter 2 2019 totaled $1.7 billion. 
Non-life ILS issuance by quarter (2014 – 2019)*

Source: Willis Re Securities Transaction Database as of 9/30/2019. Aggregate data excludes private ILS deals.
*All issuance amounts reported in or converted to USD on date of issuance. Outstanding amounts adjusted for actual principal losses.

If you have any questions or comments, please reach out to any of the contacts listed in the newsletter.

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ILS Market Update Q3 2019 PDF 1 MB
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Bill Dubinsky
Managing Director and CEO,
Willis Securities, Inc.

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