ILS investors show well-known cat-scepticism; can’t be tempted by rate

ILS investors could follow reinsurers into scepticism about catastrophe exposures despite outsize rate hardening and could eventually divert some appetite towards alternative ILS segments, including casualty, analysts at  AM Best have suggested in their latest research.

“Investors' scepticism of the catastrophe risk modelling may keep them from deploying additional capital even as prices rise to attractive levels,” analysts wrote. Five years of outsized losses are “leading some investors to question whether the modelling of cat losses is sufficiently robust.”

H1 issuance of 144a cat bonds shows a re/insurance market in desperate need of capital markets and ready to pay more for the funding, but a capital market in greater need of diversification than of increasingly attractive bond spreads.

P&C 144a cat bond issuance was down by 5% to $8.1 billion in the first half of 2022 even as spreads rose. Q2's $5.0 billion was down 16% year on year, but still larger than the prior three years.

Even as they paid more for market capital, sponsors worked to reach for ever larger sums. Some 23 of H1's 35 deals were upsized from guidance for an average increase of 36% or $1.6 billion. The aggregate for all 35 deals was up 23% above deal guidance.

Of 29 deals that could be tracked vs guidance, 22 saw sponsors give way on pricing terms in order to place their deals. Over a quarter of the deals missed sponsor hopes on pricing without any upsizes at all and even with several forced to downsize.

“Strong demand for capital in the face of constrained supply meant that sponsors had to widen the spread of their transactions to place the bonds at the sizes they needed,” authors wrote.

More deals failed in H1 2022 than in recent memory. Fifteen tranches across eight deals for $500 million had to be pulled. While those reversals “are not necessarily related to market conditions,” analysts said, “the inability to place some cat bonds seem to connect with the broader theme of market hardening.”

Others may have looked at the market and its hardened pricing and simply walked away in dismay. “Sponsors, particularly those with weaker-performing programs, who find placing reinsurance in the traditional reinsurance market difficult, also find it challenging in the cat bond market.”

With interest rates up, the cat-bond investment story of non-correlated returns and diversification could be falling prey to simple relative returns.

“There appears to be a floor of 6% to 7% for cat bond spreads, regardless of expected loss levels, sponsor quality, type of coverage or other aspects of the transaction,” analysts wrote.

The upshot could be increased demand for non-cat elements of the ILS arsenal, AM Best analysts suggested.

Industry loss warranties (ILW), albeit a smallish element of what AM Best considers a $95 billion ILS market capacity overall, have taken much of the spill over gain from a constrained cat bond market, AM Best says. “By some estimates, ILW capacity is up 20 to 25% over last year,” analysts wrote.

Interest in non-cat ILS has also increased, “especially in the casualty and liability lines,” AM Best analysts claim. Investors risk getting more correlation to economic trends than natural catastrophes deliver, but get the chance to step away from rising loss multiples on cat bonds.

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