ILS growth: could this year beat record-breaking 2021?

The insurance-linked securities (ILS) market is growing fast and ILS veteran Judy Klugman, head of ILS sales at Swiss Re, said the combination of driving forces behind this growth gets to the crux of why the market exists.

In 2021, the ILS market grew with record-breaking new issuance of more than $12.8 billion, 13 percent up on 2020 figures (also a record-breaking year). The arrival of 12 new sponsors, yet another record, certainly helped to propel this growth, Klugman told Intelligentinsurer.com.

“Not only were there 12 new sponsors, but they were a mix who came into our market. It’s not just reinsurers, it’s a combination of primary, reinsurers and governments. The government of Jamaica came to the market through the World Bank for transactions,” she said.

Other notable new sponsors included California insurer Farmers, and Dutch insurer NN.

It is the robust group of sponsors that keep propelling the market forward, she explained, as they see value in the diversifying nature of this asset class, and more particularly the liquid nature of the catastrophe bond market.
The higher volume of new issuance in 2021 bolstered the growth of the market as a whole. The notional outstanding at the end of 2021 stood at $33.8 billion, according to Swiss Re, and for the second year in a row new issuance outpaced scheduled maturities.

Since the end of 2012, the catastrophe bond market has achieved a compound annual growth rate of 9.4 percent.

Klugman said: “The premise of ILS has always been to create a robust complementary capacity source to the traditional reinsurance market. The sponsors that access this institutional capital understand that it is different—there are pros and cons to both of these markets and also from a pricing perspective.”

It’s true that sometimes one market will be more expensive than the other but it makes sense from a risk management perspective not to put all your eggs in one basket.

More and more sponsors are seeing the virtue of the diversified capacity source ILS offers, added Klugman.

Last year, Swiss Re witnessed the inflow of $1.8 billion (net) into the asset class, meaning that the new issue volumes exceeded the maturities by $1.8 billion.

“What we’re seeing is not just new capital, but capital that’s always been in this asset class, in this alternative capital space, that is being repositioned to cat bonds,” Klugman explained.

When people think of ILS they think of the liquid, tradeable 144A bonds or collateralised insurance, she added.

“But what we are finding from our investors is that their end investors are pivoting from these collateralised reinsurance mandates into the more liquid cat bond structures. We see that as being the propelling reason for that additional capital.

“We’re evangelical to new investors that this is a great asset class to diversify your broader fixed income portfolio, and what’s going on in the world to a certain extent should not impact it. Nothing is completely uncorrelated but generally speaking there’s a lot less correlation in our market to the broader markets and every year we see that rings true to a lot of investors.”

For Klugman, the investor pivot to cat bonds was “a theme of 2021”, but why has this happened now? Last year was the fourth costliest year for natural catastrophe losses in the industry, she said, which had a knock-on effect as those losses take time to develop.

“The big distinction between reinsurance and cat bonds is that one is collateralised and one isn’t. That is the beauty of traditional reinsurance: you have a balance sheet and you’re not posting $1 of collateral for each of your contracts, but if you are an asset manager and you don’t have a balance sheet then you actually have to post $1 of collateral, hence the name collateralised reinsurance,” she said.

But, at the end of the risk period of maturity, the sponsor can’t return the capital because those events are still developing, creating trapped collateral.

Klugman said that trapped collateral has negatively impacted institutional investors, prompting those investors to look at the liquid cat bond market and decide it’s a better vehicle if you have to put up collateral and a better vehicle to invest into this asset class.

Aggregates return to favour

The 2021 ILS market was interesting for another reason as investors began to rethink their stance on aggregates.

Klugman said she would put last year’s notable transactions under “one broad umbrella of aggregates”.

Aggregates have been viewed negatively over the past few years and had a “sub-par” performance on certain aggregate transactions, she explained, but a newly structured transaction had led investors to reconsider.

Prior to 2021, investors had taken “a pause and a step back” from ILS aggregates due to a large number of events that contributed to losses including wildfires, severe thunderstorms, convective storms, and other secondary perils.

However, in the first half of last year, Swiss Re brought a retooled aggregate transaction to the market on behalf of nationwide insurer USAA. At the core of this retooled deal was that it used an event deductible instead of a franchise deductible.

Historically, most aggregate structures in the cat bond market have used a franchise deductible mechanism, but investors had been concerned that with a franchise deductible, once you hit the number for the minimum amount of loss the entire amount of the loss is paid because the mechanism is binary in nature.

Klugman said that because some secondary perils were low severity but fairly high frequency, the loss numbers tend to hover around that deductible amount.

“Investors felt there was a lot of volatility around that and we saw that in the losses and the results,” she added.

Swiss Re proposed to USAA that it change from the binary franchise deductible to an event deductible. With an event deductible, only those losses above that deductible amount are included.

“In essence, the sponsor is retaining the risk below it. It takes out a lot of the volatility in some of these secondary perils. Investors were extremely comfortable with the deal as evidenced by the upside and where it was priced,” Klugman explained.

“That opened the door for further aggregates. The previous year we had not seen many aggregates but then there was USAA, and then we brought a deal on behalf of Farmers and other multiple deals. So aggregates will always play a role in our market and it’s certainly important for our sponsors.”

An investor can price something only if they know how much risk they’re taking, Klugman added. In the previous aggregate structures investors didn’t feel that they had enough certainty in that risk number.

“It was very hard for them then to put a price tag on those structures. Whereas with the new event deductible they feel a lot more comfortable with that risk profile to then price it.”

With continuously increasing demand over the past decade, and the cat bond market growing at close to 10 percent per annum, it’s no surprise that the ILS market continued to break records in 2021. And the positive momentum in the cat bond market is expected to continue in 2022, according to Swiss Re’s February 2022 “ ILS Market Insights”.

Klugman reiterated that the attractiveness of the ILS market for investors goes back to its fundamental premise: it provides a diversifying capacity source. “We don’t see anything on the horizon that would change the attractiveness.”

In terms of growth, added Klugman, this is why Swiss Re is “very optimistic” about 2022. “How much will ILS grow? We do expect new sponsors, we expect our repeat sponsors, so we’re very bullish. Do we hit that 9 percent historical annual growth rate?

“I would be extremely ecstatic if we did, but nonetheless I do expect that there should be that positive momentum in 2022,” she concluded.