ILS after HIM: Too good to be true?

The insurance-linked securities (ILS) sector’s response to the 2017 hurricane losses has been much heralded as the moment the sector came of age—the moment those who doubted the willingness of investors to take a big hit and come back for more, were proved wrong.

For the most part, that has indeed been the rhetoric of the mainstream risk transfer industry: the capital returned, investors reloaded, the ILS markets appear more robust than they have ever been.

Yet perhaps all is not quite as it seems. As the year has worn on, there have been growing murmurs of discontent—not from cedants or anyone in the traditional reinsurance sector, but from the investors behind alternative capital themselves.

Some feel, it is starting to emerge, that they were misled—or at least badly informed—by the managers of some ILS funds in the aftermath of hurricanes Harvey, Irma, Maria and Nate.

They feel this for two reasons. First, the loss estimates many funds gave at the time have proved woefully inadequate, and even as the industry moved into the renewals season in 2018, some funds were still having to increase loss estimates, harming their performance in the process.

Second, many reloaded on the promise that rates would harden. Lacking the long track record of traditional carriers, some bought the stories—backed by data, of course—of how rates can rocket in the aftermath of big losses, and the industry cashes in as a result.

Times have changed. Rates increases were disappointing to say the least. The basis on which they invested changed and some felt short-changed back in January; by September they were livid.

“There are certainly investors out there who are not happy. I have heard that some have considered legal action, certainly on the basis of how incorrect the original loss estimates were,” one ILS fund manager, whose loss estimates were relatively accurate, told Intelligent Insurer.

“There have been some tough conversations behind closed doors. At the very least this will trigger a flight to quality among investors, and funds that got it severely wrong in 2017 could certainly struggle to raise funds in 2018.”

A new landscape emerges

So-called ‘loss creep’—whereby the initial estimated losses from the 2018 catastrophes were being revised upwards—was still hitting the performance of some funds in August 2018, leading to wildly divergent performance in the sector. It was probably at its most stark in the late first and early second quarters of 2018, when it seemed some funds simply could not get a handle on what was going on.

It was mainly the aftermath of Hurricane Irma that caused the biggest problems, along with some fallout from the wildfires that also hit California last year. A complex mixture of the litigation environment in Florida, the inflating costs of loss estimators and demand surge for materials led to initial loss estimates increasing by as much as 50 percent in some instances.

The year started off with little indication of what was to come. Although some ILS funds reported negative returns in January and February, overall performance seemed to be heading in the right direction; in January, the Eurekahedge ILS Advisers Index showed an overall return of 0.54 percent; in February, however, this was starting to drop, posting a return of 0.08 percent, according to the Index.

However, in March the Index fell to a -0.24 percent return and in April the Index showed a negative return of -0.28 percent for the month. While the performance of ILS funds recovered in the next few months, posting an average return of 0.19 percent in May and 0.28 percent in June, a number of individual funds were still making losses as they grappled with the ongoing process of dealing with 2017 losses.

Some context here, however, is that while the sector’s return for May was only a little below the historical average of 0.21 percent, the year-to-date figure was the second-worst average return for the first five months of any year since the Index began recording ILS fund performance in 2012.

The divergence between the best and worst-performing funds became very transparent at this time. In an analysis of the Index published in January 2018, Stefan Kräuchi, founder of ILS Advisers, notes that in December 2017, some 24 of the 34 funds represented in the Index were positive for the month and the difference between the best and the worst-performing funds was 26.09 percentage points.

This might have been expected in the aftermath of the losses, but loss creep has meant that this trend continued well through the year. In April, Kräuchi notes, 31 of the 34 funds represented in the Index were positive for the month, but the difference between the best and the worst-performing funds was still 19.68 percentage points; in the May Index, some 29 funds represented were positive but the difference between the best and the worst-performing funds was 1.81 percentage points.

Misled or incompetent?

The problem for the ILS sector—or at least some specific funds within it—is that some investors may either regard this as something akin to incompetence, especially when traditional reinsurers and many other ILS funds have had far less trouble getting the initial estimates right or, worse, they will feel they were deliberately misled.

They will argue, of course, that it is harder for an ILS fund to get its reserves right, because they are less able to be as conservative in their estimates. Unlike traditional players with large balance sheets that can be heavily leveraged, funds must back their capacity with collateral. Overestimating loss estimates would hit returns.

Some are sympathetic to their plight. As one reinsurance broker explains: “I’m not sure they misled investors with the loss estimates; the problem was they had to be out raising capital immediately after those losses hit, at a point when they may legitimately have not had a true handle on the numbers.

“But investors wanted something. This was very different from traditional reinsurers who were able simply to sit tight and not worry about raising funds.”

The situation has raised some issues that could reshape—if not quite transform—the ILS sector and how it operates going forward. Analysts at Morgan Stanley noted this year that “uncertainty about ultimate losses could pose a short-term headwind for some ILS funds” although they also argued that the past 12 months have served to allow ILS funds to provide “proof of concept” and that they are here to stay.

Morgan Stanley also stressed that it believes what has happened will, in effect, trigger a flight to quality among investors, who will prefer to invest in ILS funds with a better track record of getting loss estimates right the first time—and perhaps also not overpromising on rate increases that never materialise. This could lead to the more successful funds growing and others shrinking or disappearing altogether.

The flight to quality

Some believe that the loss creep experienced in the aftermath of last year’s events actually represents an opportunity for ILS fund managers to explain how they operate and what sets them apart. Funds have different strategies, and ILS funds now cover the entire spectrum of risk and return levels within reinsurance risks, meaning there is a strategy for all types of investors.

These investors may also now be seeking a better understanding of what they are investing in and the process that follows a loss—the challenges facing funds in this regard are different from those facing traditional players. They will want to understand this better—as well as why some funds got it right, and others did not.

The funds will be keen to differentiate themselves on this and stress the fact that their initial loss estimates stood the test of time and have not had to be adjusted.

John Warwick, managing director and partner of ILS Capital, stresses that his funds’ initial loss estimates ended up being fairly accurate—and he is scathing of some of the funds that did not get it right.

“The difference between the actual and reported losses was just too big in some instances to be a coincidence,” he says.

“There is always a creep on big cat losses of this type but in some cases it is by 30 to 40 points. They should have had a better handle on this in the first place.”

Warwick adds that ILS Capital initially came out with loss estimates much higher than most, but these have barely changed.

“We have seen some deterioration but nothing like some other funds,” he says.

He agrees that the issue some investors will have is that they reloaded based on these initial estimates—and the fact that rate increases were mooted by many funds. He believes this experience could make investors more selective about which funds they are willing to work with.

“Some of these investors are so big, this is a small issue in the scheme of things but there could be a flight to quality in the same way as you choose the best stock company to work with,” he says.

Dirk Lohmann, chief executive of ILS fund manager Secquaero, also says that this firm’s loss estimates were accurate—and stresses that, despite some issues, the ILS sector is now regarded as a core part of the risk transfer sector globally.

“The performance of our products was largely in line with what we expected. There are some parts of the market where loss deterioration has occurred; you had some instances where the initial estimates were found to be widely optimistic. That is significant because this is one of the first losses investors have seen,” says Lohmann.

“We have not seen the same impact on our funds. We gave our clients before-landfall and after-landfall estimated ranges of what the impact would be. The actual performance was largely within or below those estimates. From that standpoint, we showed that we have a good understanding of what our exposures are.”

He adds that, in the context of increased equity market volatility at the beginning of the year, rising interest rates throughout the year and increased swings in commodity prices and emerging market debt recently, from an investor’s perspective ILS again illustrated its value proposition as an uncorrelated asset class.

The debate continues

The issue was also raised at a roundtable chaired by this publication’s sister magazine Bermuda:Re+ILS at the Monte Carlo Rendez-Vous de Septembre. The consensus was that the ILS sector passed the tests of the 2017 losses very well.

Greg Wojciechowski, chief executive, Bermuda Stock Exchange, for example, said that the sector’s reaction illustrated that it is committed to the sector and here to stay.

“Bermuda has again proven its resilience—we have the product and platform but it was great to see it being used in this way,” he said. “It was a clear testament to the fact that investors are here to stay. I think 2017 will be seen as a pivotal year by some.”

Some participants agreed that a flight to quality was now likely among investors, based on factors including loss creep.

Brad Adderley, partner, Appleby, agreed that the 2017 losses were a bellwether event for the ILS market. “There was never any question of the market not paying claims,” he said. “If anything, more money came in after the events.” He also raised the point that, of the new capital that entered the space, there was something of a flight to quality towards bigger, more established players.

Paschal Brooks, chief operating officer of AlphaCat Capital, agreed with this, noting that investors had a very good understanding of what the losses were and their implications. But he too suggested a flight to quality was now under way, partly because of the loss creep and partly because many investors reloaded quickly on the basis of projected rate increases that did not transpire in reality.

As the market now moves towards the January 1, 2019 renewals, there will undoubtedly be some funds feeling the pinch because of this—and others reaping the rewards with high levels of capacity being thrown at them. By January, we should have a better understanding of how all this plays out.

As one market observer says: “There will be funds folding by January—that is my prediction. The market was already dominated by the bigger players and what has happened will exacerbate that situation.

“As is the case for traditional reinsurers, this will become a game in which size matters.”