The ILS market has matured and is reaping the benefits of its counter-cyclical nature
The 2020 Atlantic hurricane season is coming to an end. With 28 named storms, 12 of which developed into hurricane status, 2020 is now tied with 2005 for the highest number of storms in a single season. Global warming, resulting in higher than average sea surface temperatures in the Atlantic and the Caribbean Sea, as well as the effects of El Niño, have come into play. However, despite these headwinds, the cat-bond market has delivered one of its best returns for years. There are a number of reasons for this:
First, while the frequency and severity of U.S. hurricanes remain a dominant risk in ILS (Insurance Linked Securities) portfolios, some lessons have been learned since the 2017 and 2018 Harvey-Irma-Maria and Michael-Florence sequences. Over the past two years, the outstanding amount of per-occurrence transactions (where the guarantee is triggered by a single, specific event) has increased at the expense of aggregate cover transactions (multiple events with a deductible). Per-occurrence coverage represents 44% of today’s total market, but accounts for more than 50% of new transactions issued this year. This shift has fed into our ILS portfolio strategies as they become less focused on aggregate deals, which are typically more exposed to the accumulation of medium-sized events. We have seen this scenario in 2020 with a number of small- to medium-sized loss events, which have remained below the parameters of the trigger. Consequently, the performance of ILS portfolios has proved resilient to more frequent and more severe U.S. hurricanes against the backdrop of climate change.
Second, because the ILS market consists mainly of indemnity-based contracts - i.e. contracts where the indemnity trigger is based on the actual loss experienced by the cedant - the size of catastrophe-related losses affecting a cedant company is key. The landfall area involved is also a critical factor, as some areas are more densely populated than others. This year, most hurricane landfalls occurred in areas with low population density, and consequently generated low property damage. For example, at the end of August a major category 4 hurricane - Hurricane Laura - made landfall in the western part of Louisiana, generating losses for the insurance industry that are currently estimated at USD 5-10 billion. However, if this hurricane had made landfall 100 miles to the West (Houston) or 150 miles to the East (New Orleans), the potential losses would have been in the USD 20-40 billion area.
Third, after three years of negative returns for ILS strategies with a high risk/return profile, investors have been reluctant to build-up their positions, given that part of their initial investment has been lost or has “trapped”, i.e. locked pending more clarity on the loss development of past events. The most disappointed have even exited the asset class. A supply/demand imbalance has emerged from this capacity shortage situation. The market has started to harden, with risk premiums on the rise.
What’s the outlook for the near future?
With the protection seller (i.e. the ILS investor) regaining power, the market has become more disciplined. Structures have become more transparent, with less esoteric risks involved and more clarity on perils covered, including a systematic pandemic exclusion. Consequently, ILS portfolios should become cleaner and more straightforward if they are invested in pure property cat risks. It’s not easy to evaluate the consequences of COVID-19-related business interruption, the impact of the U.S. elections or the outcome of Brexit. Many traditional portfolio managers have been losing sleep over this uncertainty. ILS portfolio managers, on the other hand, have been sleeping soundly! The asset class’s non-correlation to other markets was proven this year with a positive mid-single digit return, resilient market behavior, and a low volatility regime, even at the height of the crisis in March and April (maximum monthly drawdown of -1.8%). Against the backdrop of a low yield environment, which is expected to last for a while, inflows to this uncorrelated asset class are expected to rise over the coming months.
Article published by:
Chief Investment Officer, SCOR Investment Partners