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Cat bond investors review strategies after 2 years of losses

Investors in insurance-linked securities, or ILS, are taking stock of their participation in the market after the heavy catastrophe loss years of 2017 and 2018.

ILS are structures designed to pass insurance risk to capital markets investors, with so-called catastrophe bonds the most common form. Alongside other so-called alternative reinsurance products, such as sidecars and collateralized reinsurance, ILS now play a key role in the overall reinsurance market, in particular for covering U.S. windstorm risk.

Three hurricanes that made U.S. landfall helped make 2017 the costliest year on record in terms of insured losses, with 2018 the fourth-costliest. The two heavy loss years, which followed a prolonged period of relative quiet, have given investors a chance to see how the ILS managers they employ respond when losses hit, said Cory Anger, global head of ILS structuring at reinsurance broker Guy Carpenter's GC Securities division.

"What you are getting for the first time is an ability to evaluate managers, where you didn't have that ability before," she said in an interview. Without losses affecting their strategies, she added, "How do you know if fund A is better than fund B? This is an opportunity to test that aspect of it."

Paul Schultz, CEO of broker Aon PLC's Aon Securities division, said "we are seeing a little bit of churn," with investors "taking a fresh look at how they are going to deploy their capital and with which managers."

Investor reshuffle

According to Anger, investors are also evaluating the types of alternative reinsurance structures they want to support. Because it has taken time to determine the ultimate claims bill from some of the recent events, in particular Typhoon Jebi in 2018, investors' money has been tied up, leaving them unable to deploy it elsewhere.

A year ago, Anger noted, the focus was on more illiquid investment strategies, where it is more difficult for investors to free up their capital when losses have occurred. "The 2019 reaction has been," she said, "we need more weighting back to have the 144A cat bonds in our portfolio, so we have access to liquidity post-event."

Rule 144A of the U.S. Securities Act allows privately placed securities to be publicly traded by institutional investors, and so catastrophe bonds issued under this rule can be sold on to free up capital.

Anger also said there was also a re-evaluation of the pricing of private catastrophe bonds "to reflect that they are not as liquid as people had hoped they would be after an event."

ILS structures could evolve in response to the amount of trapped investor capital following the 2017 and 2018 catastrophes, according to Jin Shah, managing director, capital markets at risk modelling firm RMS. He said that in the loss-light years preceding 2017 and 2018, ILS structures had "softened" in favor of the ceding companies — those whose claims are covered by ILS, allowing them to hold on to capital for longer to ensure they were covered if claims eventually emerged.

"Some of that needs to be tightened up certainly, especially around trapped capital," he said in an interview. But he added that this had been less of an issue in 2018 and 2019, "so I would have hoped that the industry would have fixed some of those issues."

Turning the corner

However, although two loss years in a row were a big test for the ILS market, investors have not run for the hills en masse. Aon's Schultz noted that there has been "a plateau, even a shrinking of the asset base" as some investors have reduced their allocations or exited altogether as a result of losses. He also noted that investors have evaluated how the asset is performing for them.

But he said that as investors finish their reviews of how ILS are performing for them, "We are now seeing a little bit of a turning of the corner."

He added: "We see the fourth quarter actually leading to a good bit more of activity and we see that momentum carrying into 2020."

Anger said there had not been "substantial shifts" in the make-up of the investor base, and that pension and sovereign wealth funds had remained invested.

"In fact, there's probably a handful of very sizable funds that haven't yet made an investment in this space that are on the cusp of making it," she said. "That to me validates what we have done."