The insurance linked securities (ILS) market is now over two decades old. Since the execution of the first catastrophe bond transaction in the late 1990s, the alternative risk transfer market has evolved and matured impressively. Guy Carpenter Asia Pacific’s Shiv Kumar provides some insights.
The alternative risk transfer market grew rapidly after the global financial crisis of 2008 as investors recognised the clear diversification benefit of this asset class.
Cedants and investors now have access to a broad range of collateralised structures to hedge and assume insurance risk. After surviving the loss events of 2004-2005, the sector faced its second test in 2017, with major events in North America incurring significant losses. The ILS market handily met the challenge with very few hiccups and is now poised to continue its growth around the world, including the Asia Pacific region.
Meeting the challenges of 2017
The ILS market’s response to the major catastrophes in 2017 demonstrated that it could handle one of the costliest years in the history of the (re)insurance industry. After several years of below-average loss activity, hurricanes Harvey, Irma and Maria in North America generated total insurance industry losses of over $64bn in 2017. Further, the California wildfires contributed nearly $13bn to insurance industry losses (as estimated by Property Claims Services). These events resulted in principal write-down of some ILS as well as impairment of others in the secondary market.
Despite the loss activity, the ILS market remained resilient. The outstanding transactions proved to have robust structures and the underlying coverage was responsive to cedants’ needs. The collateral mechanisms, which were significantly redesigned after the 2008 experience, were insulated from institutional credit exposure as proceeds were primarily invested in US treasury money market funds. There have been no reports of any significant legal dispute in the payment of incurred losses.
The investor base was very constructive through these major events. The most significant evidence of the ILS market’s maturity is the fact that total alternative capital in the insurance sector has grown to over $95bn even after accounting for the 2017 loss activity. New issues continue to get excellent reception and transactions are routinely upsized following strong demand after the initial announcement.
Investor appetite remains strong
Through mid-August 2018, $8.4bn had been raised through 24 catastrophe bond transactions. This pace is similar to last year, when the total new issuance of catastrophe bonds exceeded $10bn. Investors are showing appetite for first-time sponsors and for new perils while strongly supporting repeat issuers. They are also welcoming corporate sponsors as well as the public sector.
In a continuing low-interest rate environment, investors are seeking interesting opportunities to put capital to work. The ILS market provides them with a selection of expertly-modelled risk in proven structures with varying degrees of liquidity. By supporting new transactions, investors are taking the opportunity to balance and diversify their portfolios across multiple geographies and perils.
An evolving reinsurance cycle
The rise of the ILS market is affecting the reinsurance rate cycles that have been a standard in the industry for decades. In the past, reinsurance rates typically increased significantly after major loss activity with industry capital coming under pressure. The rate increases have been much more muted in the post-2017 renewals. The existence of a robust ILS market allows capital to flow easily in and out of the industry, which results in rates remaining relatively stable post-event.
Recent market experience bears this out. Given the benign loss activity since hurricane Sandy in 2012, reinsurance rates fell every year through mid-2017. But even with the major 2017 loss events, rates were up only modestly through the first half of this year. If the 2018 hurricane season is mild, there could be continued rate softening driven by increased capital from the ILS investor base.
ILS continues to expand global reach
The ILS market continues to grow, and there have been several notable developments in recent months. This summer, Guy Carpenter and GC Securities brought to market the $500m FloodSmart Re catastrophe bond transaction on behalf of the US government’s Federal Emergency Management Agency (FEMA) and National Flood Insurance Program (NFIP). This is the first catastrophe bond ultimately to benefit a US federal agency and the first bond dedicated solely to the flood peril.
GC Securities also brought the $200m PG&E-sponsored Cal Phoenix bond to the market, the first catastrophe bond to provide indemnity coverage to a corporate sponsor, as well as the first bond to solely cover the wildfire peril.
In Europe, GC Securities brought the SCOR-sponsored Atlas bond to the market, which was the first UK-domiciled cat bond following a new regulatory framework in the UK allowing for UK-domiciled insurance special purpose vehicles and protected cell companies with certain tax exemptions. This regime should make ILS transactions more accessible for European cedants, who are now familiarising themselves with the new regulations.
In Latin America, the government of Mexico has been transferring natural catastrophe risk to the ILS market for some time. This year we have seen the World Bank help four governments – Chile, Colombia, Mexico and Peru – come together to sponsor the Pacific Alliance transaction to cover earthquake risk.
While Asian and Australian investors are well represented in the ILS space, there has been limited issuance activity from the Asia-Pacific region in the past. One of the reasons for this lack of activity has been the absence of a suitable local jurisdiction for establishing an ILS vehicle. With Singapore taking a proactive approach to becoming an ILS domicile for Asia, the dynamics are expected to change in the near future. Singapore already has regulation in place for special purpose reinsurance vehicles and is in the process of introducing regulation for protected cell companies for collateralised reinsurance. As the cedants become more educated about the ILS product, investors seek more diversifying risks and local regulators encourage more collateralised transactions, it will be natural for the ILS market to grow in the Asia-Pacific region. A
Mr Shiv Kumar is GC Securities president and global leader with Guy Carpenter Asia Pacific.
Guy Carpenter & Company, LLC provides these responses for general information only. The information contained herein is based on sources we believe reliable, but we do not guarantee its accuracy, and it should be understood to be general insurance/reinsurance information only.