Maren Josefs London +44-20-7176-7050
Johannes Bender Frankfurt +49-693-399-9196
Ali Karakuyu London +44-20-7176-7301
Taoufik Gharib New York +1-212-438-7253
Retrocession, in which reinsurers transfer risks they have assumed to other counterparties, remains a flexible and strategically important way for the reinsurance market to manage its exposures. Despite significant rate increases in the retrocession market in the recent past, companies have continued to employ the practice (see "Five Years Of Over-Budget Catastrophe Losses Test Global Reinsurers' Discipline"). As of Jan. 1, 2021, reinsurers ceded about 50% of their 1-in-250 exposure off their balance sheets. Half of this cession was collateralized, indicating the importance of third-party capital to the market, i.e., employing insurance-linked securities (ILS) to manage catastrophe exposure.
Chart 1 | Midsize Reinsurers In Particular Are Increasing Their Use Of ILS Capital Collateralized cession as % of total ceded recoveries at a 1-in-250-year return period
Source: S&P Global Ratings.
Overall, ILS capital maintained a 15% share of total reinsurance capital in the first half of 2021, according to Aon (see chart 2), while the share is significantly increasing within the retrocession (retro) market. The trend of rising capital is not only occurring in the reinsurance space but also for ILS capital. This ILS or third-party capital expanded by $3 billion to $97 billion year to date from a recent low of $94 billion in 2020. This reverses the trend of decreasing ILS capital we have seen in the past two years and affirms the attractiveness of ILS to investors as an alternative asset class. We expect the percentage of ILS capital to incrementally increase.
Midsize reinsurers, in particular, have steadily increased their use of third-party capital (see chart 1). It now accounts for about two-thirds of their ceded exposure at a 1-in-250 return period. This confirms our observation that some reinsurers are increasing their market share to take on more catastrophe risk, and leveraging their third-party capital vehicles to do so. The largest global reinsurers have kept their use of collateralized reinsurance steady at just under 50%. Smaller and more regional reinsurers appear to cede less to third-party capital, possibly because they value the support and expertise they receive from their counterparts. They might also lack the expertise or resources to issue and administer their own ILS issuances. That said, average utilization rates conceal a wide range of coverage. Large global reinsurers typically cede less risk, especially in an environment of rising rates, whereas smaller players might need extra capacity to write the same amount of exposure or offer higher limits.
As anticipated at the start of the pandemic, investors’ interest in catastrophe (cat) bonds, a type of ILS, has steadily increased over the past year (see chart 3). A main driver behind the interest is the low correlation demonstrated with other asset classes at the beginning of the pandemic when the markets were in turmoil. Cat bonds usually work on a named-perils basis and cover predominantly residential risks, which also means that losses for cat bond investors from the pandemic or secondary perils were limited. As such, even if we were to come out of the low interest rate environment in the future leading investor interest to swerve to other asset classes, we expect cat bonds to remain attractive from a portfolio construction point of view.
Chart 3 | Cat Bonds And Collateralized Reinsurance Are Fueling Growth Of Alternative Capital For Reinsurers ILS capital split of different instruments
Source: Aon Securities Inc.
Chart 2 | Global Reinsurance Capital Continues To Increase In Response To Increasing Demand
Mostly 144a securitizations of catastrophe risk, which is directly sold from the cedant to qualified investors via a special-purpose vehicle. Investors lose the bonds principal if the predefined event (trigger) occurs, and money is paid out to the cedant. Premium is paid as coupon to investors.
An insurance special-purpose vehicle created by the cedant. By investing in a sidecar, investors can participate in the risk and return of a specific group of insurance policies via a quota share agreement and the liability of investors is limited to the funds of the sidecar.
Risk transfer occurs via a reinsurance agreement. The protection provider has to deposit the funds in a trust account to cover its maximum liability in the event of a claim(s) under that contract.
A reinsurance or derivative contract that pays out when the financial losses experienced by an industry exceed a specified threshold.
This is good news for cedants needing to replace their maturing cat bonds or looking for retro protection while market capacity is still constrained. Cat bond and other ILS issuance by rated reinsurers over the past 10 years clearly shows the trend of reinsurers making good use of ILS capital.
Chart 4 | Reinsurers Are Embracing Use Of Third-Party Capital ILS issuance of top 20 reinsurers 2011-2021
*Excludes sidecars. ILS--Insurance-linked securities. YTD--year to date. Source: Artemis.
The average expected loss for recent cat bond transactions has been decreasing (see chart 5), which could be a sign that cat bonds are used by cedants for risk transfer to third-party capital for more remote exposures/layers. At the same time, investor demand for cat bonds is pushing down prices, which has led to the average multiple (expected coupon over expected loss) to reduce to 2.4%, edging closer to the low we saw in 2017. With climate change one of the bigger worries for ILS investors, continuation of a disciplined underwriting should therefore be the focus of all ILS investors to ensure that short-term gain does not lead to longer term pain.
Chart 5 | Investor Demand For Cat Bonds Is Pushing Down Prices
*As of Sept. 21, 2021. Source: Artemis.
Sidecars and collateralized reinsurance positions proved much more illiquid than cat bonds during the pandemic. These instruments are typically more prone to losses that can occur with higher frequency and have broader exposure across unnamed perils and commercial risks. As a result, investors experienced losses from secondary perils, such as wildfires and from unmodeled pandemic-related business interruption claims, with some still waiting for their capital to be released. Understandably, investor demand in these asset classes of ILS was temporarily dampened.
While sidecars or similar quota share agreements provide capital to drive growth and also moderate probable maximum losses for cedants, they also provide some attractive fee income and enable reinsurers to better manage their exposures. With rates going up, it is also not surprising to see smaller players needing sidecar capacity more than the big reinsurers. The latter can afford to retain more risk on their own balance sheets in the current rate environment.
That said, collateralized reinsurance has also benefited from the pricing trends of traditional reinsurance and is now offering additional return potential, and some secondary perils are modelled and priced for. At the same time, negotiations at contract renewals allowed reinsurers and investors to demand pandemic and silent cyber exclusions.
Overall, ILS funds’ results have been positive in 2020 and 2021 to date (see chart 6)--despite a 0.82% decline in the past three months due to losses from Hurricane Ida. However, results have not been at the same level as prior to 2017. With the hurricane season coming to an end soon the possibility of negative returns might just have been avoided.
Chart 6 | Insurance-Linked Securities Funds' Results Were Positive In 2020 And 2021 So Far
*As of September 2021. Source: Eurekahedge.
The past two years have seen innovative ILS issuance addressing different emerging needs (see table 1).
These needs include:
The market is also witnessing new issuers, including corporates, which are embracing the benefits of purchasing cat bonds for they own risk mitigation or as a tool to address the widening protection gap exposed by the pandemic.
Furthermore, the pandemic-related acceleration of digitalization over the past two years has been accompanied by an increase in cyber attacks, which have provided the risk management community with critical learning opportunities. Such events, which can be connected across different lines of business, geographies, and economies, are becoming increasingly complex and leading to new emerging risks. We believe there is a role for the ILS market here (see "Cyber Risks In A New Era: Reinsurers Could Unlock The Cyber Insurance Market"), especially if it can provide capital in cooperation with industries and government. This would however necessitate a massive expansion of the investor base. The ILS market currently has only a limited amount of capital, which is far outstripped by the forecast exposure and potential demand for cyber protection.
Considering the potential demand, the ILS market is also looking at opportunities to attract ESG-oriented investment. Although the Sustainable Finance Disclosure Regulation which came into effect in March 2021 was not created specifically for ILS, the providing insurance has ESG qualities, although this is not sufficient to meet the new guidelines. To satisfy the regulations, the ILS market needs to establish widely agreed definition and disclosure for assessing transactions and new processes, which are still under development.
ILS capital, 2020
ILS capital, 2021 YTD
In our view, the ILS market will continue to play an important role for reinsurers. The more peak exposures the reinsurance market transfers to a broad range of ILS investors, the better for the stability of the system and the growth of the market.
In terms of returns, this year remains uncertain. Given the occurrence of fresh catastrophes, 2021 natural catastrophe losses are likely to exceed reinsurers' budget expectations yet again.
Table 1 | Innovative ILS issuance Addressing Emerging Needs
Issuance date
Issuer
Cedent/Transformer
Ultimate beneficiary
Description
Size
Reason
Sept. 2020
Power Protective Re Ltd.
White Rock
Los Angeles Department of Water & Power
Parametric Californian wildfire protection for power network
$50 mil.
Risk mitigation
March 2021
Dunant Re IC Ltd.
Replexus ICC (Guernsey) Ltd.
Danish Red Cross
First humanitarian cat bond for Danish Red Cross to provide aid in the aftermath of a volcanic eruption
$3 mil.
ESG / Protection gap
June 2021
Wrigley Re Ltd. (Series 2021-1)
Gryphon Mutual Insurance Co.
Blackstone
Parametric California earthquake protection for portfolio of real estate investments
Lion III Re DAC
Assicurazioni Generali SpA
European windstorm, Italy earthquake
$200 mil.
ESG / Risk mitigation
Sept. 2021
Greater Bay Re Ltd.
China Property and Casualty Reinsurance Co.
First issuance out of Hong Kong, China typhoon protection
$30 mil.
New peak zones
Oct. 2021
Acorn Re Ltd.
Hannover Rück SE / Oak Tree Assurance Ltd.
Oak Tree Assurance Ltd.
Parametric U.S. earthquake protection for workers compensation insurer
$400 mil.
According to Swiss Re, the first six months of 2021 delivered the second-highest natural catastrophe-insured losses ($40 billion versus a 10-year average of $33 billion), with Winterstorm Uri in Texas in February being the costliest event ever recorded for the peril of severe convective storms and winter storms. Added to this, there have already been two further major events in the second half--floods in Europe and Hurricane Ida in the U.S., with estimated insured losses of about $13 billion and about $30 billion, respectively. The ongoing U.S. wildfire season poses a further potential threat to reinsurance and ILS markets. We therefore forecast that 2021 will be the fifth year in which the reinsurance industry will fully consume its catastrophe budget. This will put further pressure on rates, with more increases expected at the upcoming renewals.
Despite these setbacks, we expect investor interest in the ILS asset class to remain strong, as long as the market stays disciplined. We therefore expect the ongoing flight to good quality ILS asset managers to continue. Investors are looking for good performance without adverse loss development, understanding of climate change-related risks, and transparent and timely investor communication. If the ILS market can deliver this, we might just be at the cusp of another growth spurt for the market.
