ILS, while still new, is a growing asset class that can provide a unique solution for captive owners. Barney Dixon finds out why
As a relatively new asset class, insurance-linked securities (ILS) can be a very attractive proposition for investors and insurers. ILS performance is driven by events in the natural world, rather than the corporate, offering an opportunity for investors to diversify their assets outside of traditional stocks and bonds. By its nature, performance of ILS is linked to insurance loss events, most commonly in the form of catastrophe bonds — the reinsurance of high severity, low probability events.
While ILS is mostly known for catastrophe bonds, the industry is starting to expand beyond those exposures and exploring new lines in other areas.
According to Paul Schultz, CEO of Aon Securities, ILS is an asset class that creates “an alternate source of capital for insurers, reinsurers, corporations, and governments, compared to the traditional reinsurance model.”
He adds: “ILS looks to transfer risk from these sources into the capital markets.”
Schultz notes that the risk has predominantly been around catastrophe exposures, but that the asset class is expanding into other areas such as cyber.
“ILS is just over 25 years old. And while to each of us individually that’s a long time, when compared to other fixed income strategies, it’s still pretty novel.”
Schultz says: “ILS was first created in the 1990s after Hurricane Andrew in the US. The founding principles around the asset class are to bring a larger capital base, to a risk that itself is probably too large for the private insurance and reinsurance markets, and where volatility is generally accepted.”
“For investors, what that creates is a new asset strategy that’s not correlated to a traditional asset strategy around fixed income or equities. Hurricanes in Miami and earthquakes in California are really not correlated, except by very remote tail exposures. So it’s a way to increase the efficient frontier portfolios, but in a way that diversifies risk for investors.”
The relationship between captive insurance and ILS
For captive owners, ILS can be an attractive alternative
risk transfer strategy.
Captives have generally relied on the traditional reinsurance market, but ILS can potentially offer a lower cost of coverage,
or allow the captive to gain coverage that goes beyond
traditional reinsurance.
According to Schultz, Aon has seen captives being used “primarily by corporations accessing the ILS market and catastrophe bonds.”
“We’ve seen captives be the entity that’s more or less engaging in these types of transactions.”
“We feel like there is a very meaningful role for captives in helping companies and corporations transfer risk. One of the very differentiating features of ILS is it tends to be multi-year, so a company that used its captive to buy ILS a couple of years ago really has not experienced the volatility in the property markets that traditional buyers have seen over the past 12 to 18 months, as the ILS terms were locked-in three or four years ago.”
He adds: “Those terms are very attractive now, on a relative basis, compared to where the cost of those products and risk transfer capacity is today.”
Schultz notes that the long duration and maturity around ILS that capital market investors are willing to provide is a “hedge against the annual volatility of the insurance product.”
“Those who have done that are in a preferential position, just given where their costs are today.”
“We do expect corporations to grow in their use of ILS capacity, and we think that the likely way to execute or transact for corporations is to use their captives.”
Steady growth
According to Aon’s Q4 2022 Post Hurricane Ian Market Update, the ILS market grew year-over-year in 2022, with issuances outpacing maturities by US $2.2 billion. Q4 saw $1.34 billion in notional issuance from nine sponsors. Aon notes that while issuance volume wasn’t ‘record-setting’, sponsors were able to “secure meaningful capacity from the ILS markets to complement their traditional reinsurance and retrocession placements.”
The report also notes that the aforementioned, as well as increased catastrophe activity over the past five years, has “pushed the bond market into a higher total return environment, with material increases in overall pricing, accompanied by higher collateral returns.”
Initial indications for Q1 2023 show the market has “built on this orderly year-end renewal” and there has been a “positive shift in momentum” across the market, according to Aon.
“With the early year pipeline smaller than anticipated, maturing issuances not entirely matched with new capacity and investors experiencing capital inflows, Q1 2023 sponsors of catastrophe bonds have benefited from positive execution, both from a pricing and size standpoint. Such market signalling is sure to bolster the catastrophe bond pipeline through the end of Q1 and into Q2 as sponsors continue to seek alternate capital solutions,” the report says.
Schultz says 2022 was “clearly an interesting year, due to some of the everyday macroeconomic factors in the markets — inflation and currency movements, for example. Hurricane Ian hit the US towards the end of Q3, but the market reopened for issuance fairly quickly following the events.”
He notes: “Some of the early transactions were just a little bit more challenging to get to the finish line, but as we got closer to year-end, capital seemed to flow a little bit easier. We’ve seen the momentum grow as we turned the corner into 2023, and capital is actually increasing as we speak, in part due to a very significant reset of return.”
Schultz says the industry is in a more “opportunistic” return to investors, given the macroeconomic impact.
“It appears that ILS has a very sound footing,” he says, “I think we once again have proved the durability of the asset class through these types of events and types of volatility.”
“And, if nothing else, I think we’ve seen a growing confidence that catastrophe bonds, as an example of ILS, are really going to withstand these types of volatile markets in the future.”
Aon’s view, going into 2023, is that the market could easily set new issuance records — more than US$11 billion issuance of catastrophe bonds.
Schultz concludes: “There’s a good base of transactions that are due to mature or expire and then can be rolled over. Some of that $11 billion clearly will be transactions that we expect to renew and issue again. But we’re also seeing a much higher interest from those that haven’t issued or sponsored a catastrophe bond recently. We expect there to be new participants as well this year.”
“All in, we’re pretty bullish on the continued diversification from those looking to transfer risk, and to continue to issue catastrophe bonds — whether they be insurers, reinsurers, corporations, or government schemes.”
