Bloodied but Unbowed

When USAA issued its first Residential Re catastrophe bond back in 1997, raising $480 million for U.S. hurricane reinsurance protection, it was only the second such instrument ever issued.

At the time, I wrote that the economics of the transaction didn’t seem to make sense either for the investors or for the issuer. Since then, USAA has issued 34 bonds in total that provided the insurer with catastrophe risk capital of $8.361 billion. According to Artemis, a publication which monitors such things, $42.3 billion worth of catastrophe bonds and other insurance-linked securities were outstanding at the time of writing, of which nearly 10% have been issued in just the first two months of 2020. Multiple extremely valid caveats notwithstanding, I called it wrong.

I had pronounced the death of the ILS baby before it was even out of the crib, but since then, a great many voices foretold the end of the “alternative risk transfer” market, especially after the catastrophes of 2017/18. Since those adolescent ILS growing pains, however, this highly specialized market has proven its maturity by emerging stronger than ever. Willis Re reported in November that outstanding ILS capacity at the end of the third quarter of 2019 was at a near-record high of $27.3 billion. Guy Carpenter, the reinsurance broking arm of Marsh, declared more recently, “In the aggregate, heading into 2020, investor appetite for the insurance-linked securities sector remains strong, and the thesis for long-term strategic allocation to this diversifying asset class continues to be intact.”

A fair number of pundits (among them many traditional reinsurers who saw others eating their lunch) had believed that ILS investors would walk away from the risky catastrophe insurance business after their first big round of losses. When hurricanes Harvey, Irma and Maria hit in 2017, cat bonds suffered their first truly capital-consuming losses, and the terms “trapped capital” and “reload” become common parlance in the reinsurance world. Investors wouldn’t tolerate the former and couldn’t stomach the latter, it was believed. Investors did reload, to the surprise of many, but 2018 brought more ILS losses, and the market stuttered. “Due to the frequency and nature of the events, in addition to the loss creep [the escalating losses from Hurricane Irma and Typhoon Jebi], end investors did not rush back into the market like in 2018,” Swiss Re declared in a September 2019 ILS market update.

That was then. Cat bond and ILS issuance topped $3.3 billion in fourth quarter 2019, fully 50% above the 10-year fourth-quarter average. Conclusion: bloodied but unbowed, ILS are here to stay.

Challenges Overcome

One by one, the structural challenges of ILS are being overcome. For example, reinstatements (the process which restores reinsurance or retrocession coverage after it has been burned away) are now possible under a cat bond. The cost of issuing bonds and other ILS instruments has fallen dramatically since the early offerings of the late 1990s. The cost reduction has happened not only due to the now-widespread understanding of the risks, rewards, and especially (from an investing fund’s perspective) uncorrelated nature of the asset but also through structures such as the so-called “cat bond lite,” with its minimal disclosure and reporting requirements (although these instruments are now losing ground to other ILS structures due to their limited liquidity).

Critically, all of that—plus the sheer volume of insurance-linked securities outstanding on any given day—has given rise to the emergence of a credible and robust secondary ILS market. Traders include scores of dedicated ILS funds, some run by conventional industry players, others by investment-focused asset managers. Meanwhile every top- and mid-tier reinsurance brokerage has built or acquired at least some capital-markets capability.

The scope of insurability under ILS instruments has expanded. Last year saw U.K. reinsurer Pool Re launch the first-ever cat bond dedicated to terrorism risks; the newest coronavirus has placed the World Bank’s pandemic cat bond at risk; and the securitization of mortgages through ILS instruments (a much safer prospect than it sounds, we are assured) has stormed ahead, with mortgage risk the largest peril transferred under reinsurance bonds in 2019.

The secret to winning over investors and securing a successful issue is to grant them sufficient confidence in expected loss figures. Advances in modeling have helped this along and continue to make strides. Meanwhile the range of triggers, from indexed industry losses to indemnities and parametric thresholds such as windspeeds, have added diversity.

In addition, since the 2017/18 losses bedded own, investors have begun to focus intently on qualitative aspects of the sponsor of the bond. Deals are assessed not just on their risk/return ratio but also on the accuracy of the issuers’ previous early loss-quantum reporting, and even on the performance of the people who will adjust claims and manage potential litigation, based on their track records. Investors may have become even more astute than the issuing sector had hoped.

But Another Test Lies Ahead

Right now, as I write, the rate on U.S. Treasury bonds is 0.85%. At their current low level, a pension fund can make 85 basis points on risk-free three-year U.S. Treasurys. Alternately, the loss-free top layer of a major insurer’s European wind cat bond might promise 275. That’s more than three times the risk-free rate. When we move into a world where Treasurys start yielding 3% (still a very low rate, historically speaking), the return on that cat bond layer shifts from 3.6 to 5.75, the T-bills plus the 275 basis points.

But a much more dramatic change also occurs. The cat bond investment evolves from proffering a return three times greater than the risk-free rate to one just 1.6 times the risk-free rate. True, amid the viral soup of uncertainty currently spreading across the globe, it is difficult to imagine significant rate increases. But that’s what I thought in the 1980s when the rate on my government-secured student loan rose to 14.5%. The next time we see interest rates touch double digits, I expect ILS will be immovably entrenched.

About the time you read this column, the big commercial brokerages will be issuing their comprehensive reviews of ILS in 2019. Each will pronounce the record-breaking growth of the ILS market and show how it now constitutes an even greater share of the global reinsurance capacity pie. According to Aon Securities, that figure was 16.6% at the end of 2018. Swiss Re stated late last year that ILS now account for about a quarter of the total property-catastrophe risk supply and absorbed 25% to 30% of the 2017 Atlantic hurricane season’s insured devastation.

California earthquakes, Florida hurricanes, Texas hailstorms, and even flooding on the New York subway are all protected in part by catastrophe bonds. There’s a fair chance your mortgage is covered in this way by the capital markets, too. Along with the rest of the reinsurance market, the pricing of catastrophe bonds and other ILS reinsurance instruments is rising, and investors are flooding back. I’ll say it again, ILS are here to stay.