While the ILS industry proved resilient in 2020, industry participants discuss potential market developments including the partnership between captives and ILS
The insurance-linked securities (ILS) market continues to remain resilient despite the disruption from the start of the COVID-19 pandemic last year. Direct losses from pandemic risks were mostly limited to the World Bank’s pandemic catastrophe bond which was triggered in mid-2020.
New ILS deals continued to come to the market even as participants adjusted to the new normal of remote working and virtual meetings.
Sherman Taylor, executive director at Ocorian, says: “Unsurprisingly, the initial uncertainty that COVID brought to the capital markets slowed deal flows in the early part of 2020. However, by the second half of the year, ILS was well on track to deliver what was another record-breaking year, with annual ILS issuance at $16.4 billion.”
The 2020 Willis Towers Watson (WTW) report on the ILS market, also showed market resiliency. It found that most end investors were satisfied with their ILS performance, with 86 per cent of ILS funds expecting market growth of 5 per cent or more cumulatively during the next five years.
It also highlighted that more than half of reinsurance and insurance companies surveyed worldwide now use ILS capacity.
Bill Dubinsky, managing director and CEO, Willis Re Securities, explains that while COVID-19 is certainly not over by any stretch of the imagination, the ILS market seems to have largely escaped significant loss activity and handled work from home quite well from an operational perspective.
He says: “That said, assets under management plateaued as COVID-19 made it challenging for ILS funds to raise new funds to replenish assets under management following significant non-COVID-19 loss activity in 2017 and 2018. For 2021 we predict we will see a return to ILS assets under management growth notwithstanding continuing challenges from COVID-19.”
However, Rupert Pleasant, chief executive of Guernsey Finance explains the consequences are still being assessed and understood, but “COVID has and will affect the ILS market, particularly around the constant theme of trapped collateral.”
At its most basic level, COVID increases uncertainty around claims reserving which will slow the release of collateral back to investors. Pleasant says: “This diminishes returns and makes it harder to redeploy that capital into new deals. Over the longer term, there is still uncertainty as to the full impact of the pandemic in the ILS space, but it will depend largely upon individual ILS managers’ portfolios.”
ILS developments
In the early days of ILS, there was intentional commoditisation of the ILS asset class, with many deals looking very similar in structure and geographic area covered, and underwriting risks are undertaken.
At one stage, ILS typically only covered catastrophe risks such as hurricanes, earthquakes and windstorms. But Taylor suggests that in the last five years, there has been a broadening of the general structure of the ILS deals, and coverage of more unconventional risks such as credit default risks, operational risks, terrorism risks, and even pandemic risks.
He says: “The geographical areas of cover have also expanded with ILS deals now covering regions of Latin America, Asia and even Africa. This is the trend we expect to see continue as the asset class becomes more mainstream.”
The ILS industry is set to see an expansion not only in the total amount of ILS capital available but also in the number of use cases such as new risks, new protection buyers and new products. While most of the protection buyers in the past have been property and casualty insurers and reinsurers, Dubinsky says: “Increasingly, we are seeing corporates, government entities, as well as life, health and mortgage insurers, availing themselves of ILS solutions.”
Another trend within the ILS market is the challenging claims conditions and climate change consequences on one hand with increasing maturity, acceptance of the asset class and a hardening reinsurance market on the other, according to Pleasant.
He comments: “Alternative capital has remained static as a proportion of overall reinsurer capital in the last three years at 17.5 per cent to 20 per cent of the total market capacity. That said new ILS issuances was more than $15 billion in 2020, so another record-breaking year for ILS.”
Meanwhile, a trend towards cat bonds over collateralised reinsurance, which Pleasant suggests could be as it is considered more liquid and peril-specific in nature.
ILS and captives
One particular development is the partnership between ILS and captives. Those in the captive insurance industry have been anxiously awaiting their chance for their very own tailor-made ILS solution to meet captive needs, according to Michael Douglas, director, business development at Aon.
He comments: “Well not to be a New Year buzz kill, but we are just not there yet. However, the increasingly wider use of the ILS market as an alternative risk financing tool for a captive’s catastrophic loss exposure is getting us closer to it becoming a reality.”
The availability of ILS options has proven to be especially useful during hardening market conditions where traditional insurance and reinsurance capacity has been reduced.
The insurance market has been hardening for several years and this trend is predicted to continue. This market situation raised awareness for alternative risk management such as captive insurance and ILS structures.
“Reinsurance cover now can be provided through a cat bond usually issued as a collateralised reinsurance policy directly to the captive, or more commonly through a special purpose vehicle set up specifically to provide coverage as the transformer vehicle. The transformer holds the funds and acts as the matchmaker to make the connection between the captive the investors’ capital,” he adds.
Increased traditional insurance and reinsurance pricing together with reduced capacity during 2019 and 2020 have created the need for captive owners to seek out alternative sources of risk financing including ILS options.
To date, Douglas explains that most ILS solutions have been confined to larger transactions of over $100 million each and as a result has been out of the reach of most captive insurance companies or their owners.
But the landscape is changing again, and investors are starting to seek additional market opportunities for a large number of relatively smaller transactions.
During 2019 and 2020, Douglas highlights there was a marked increase in the number of smaller deals ranging from $3 million to $25 million, also called ‘micro cats’.
Besides the diminished size of the transactions, there is also a movement to test ILS capabilities and to move away from the large earthquake and hurricane disaster risks to more regionalised and medium risks such as hailstorm, crop insurances, or large fire losses.
While still in their start-up mode, Douglas says: “There is growing interest from the ILS market to diversify exposures and expand penetration into new markets where the demand is high, the transactions are numerous, but likewise are smaller in size.”
“This represents a natural next step for the ILS industry and shows that it is a maturing market looking for growth and new opportunities,” he comments.
With the current surge of interest in using captives, and those new captives taking on a larger amount of catastrophic risk, Douglas highlights that there is a “prime opportunity for the two markets to work together to accomplish each other’s goals”.
He notes: “For investors, the ILS market offers an investment which is uncorrelated to the rest of their portfolio, and as such, offers diversity as well as an attractive rate of return.”
“For the ILS investors, partnering with captives will provide direct access to a virtually untapped market that has a need for their services, and for the captives, ILS solutions can help with mitigating the large loss exposures in a more cost-effective manner.”
All signs are pointing toward a period of collaboration and cooperation between these two maturing ‘alternative risk transfer’ markets.
Douglas adds: “We may not get there overnight, but with the current market conditionswe should keep looking under our seats and seek to be part of the next wave of reinsurance success. This will help propel captives and ILS even further into the risk transfer landscape for the third decade of the 21st century
