ILS Market Has Been Tested by Losses but Continues To Grow

New issuance of catastrophe bonds and other insurance-linked securities (ILS) may vary from year to year, but over time the volume of reinsurance capital represented by the outstanding securities in the marketplace has steadily grown.

A recent commentary from A.M. Best cited estimates of the market's capacity ranging from $88 billion to $93 billion.

Since the 1990s, the ILS market has both grown and matured. And, in responding to losses, it's demonstrated its viability as an alternative method of ceding risk.

In its commentary, "Insurance-Linked Securities Market Looks to Future after Servicing Record Cat Losses," A.M. Best said a series of catastrophic losses exceeding $220 billion from July 2017 through December 2018 "put the ILS market to a severe test."

But, the commentary said, "Overall the market performed as it was designed because it proved to be a reliable provider of collateralized reinsurance.

"Even after a series of severe catastrophe events there appears to be ample capacity in all but the hardest hit segments/regions such as the aggregate retro market and, possibly, loss-affected areas such as in Florida and Japan," the commentary said.

Insurance-linked securities are derivative or securities instruments linked to insurance risks. ILS value is influenced by an insured loss event underlying the security. This securitization model was born of efforts by the insurance industry to develop an additional source of insurance and reinsurance capacity by transferring traditionally insurable risks to the capital markets.

As the ILS market has developed, it has provided an alternative source of risk capital, most often for property catastrophe risks such as windstorm and earthquake, though insurance-linked securities have also been used to transfer life insurance exposures, such as mortality and longevity risk, as well as other risks.

Insurance-linked securities have proven popular with the institutional investment community, which prizes their healthy returns. In addition, because ILS value typically is not tied to broader financial markets, investors see them as a means of diversifying their portfolios beyond their typical holdings.

According to the Artemis Deal Directory, ILS transactions in recent months have covered such risks as typhoons, earthquakes, fire, severe thunderstorms, volcanic eruptions, and meteorite impacts, as well as mortgage insurance risks and medical benefit claims levels.

In a recent report, Artemis noted that ILS issuers are coming to market in this year's first quarter at a record pace.

The Artemis report said that data from its Artemis Deal Directory shows that the anticipated first-quarter volume of $5.1 billion in new catastrophe bonds and insurance-linked securities is 84 percent higher than the same period in 2019 and a 21 percent increase from the previous first-quarter record of more than $4.2 billion set in 2018.

In its commentary, A.M. Best identified several other broad issues in the ILS market that were highlighted by the losses over the 18-month period from July 2017 through December 2018.

Among those issues is that the magnitude of losses surprised investors, as did the uncertainty around loss figures associated with some catastrophes, A.M. Best said. The result is that investors will likely ask more questions about the following.

• Losses at the tail end of probable maximum losses (PMLs)
• Risks ILS funds are taking on
• Accuracy of risk modeling

Another issue is the rights of cedants and ILS investors, which might not always fully align, A.M. Best said.

Cedants face possible tail risk when collateral is released to investors before losses have fully developed, the rating agency said. "This issue undoubtedly cropped up on several occasions over the past few years given the extreme loss creep associated with catastrophic events like Hurricane Irma and Typhoon Jebi."

Among the possibilities, buffer loss tables—which govern the schedule for releasing collateral back to investors—become more conservative, according to the commentary. "Cedants and investors have to find a mutually beneficial meeting ground to coexist," A.M. Best said.

The losses over the 18-month period also highlighted the need for standardized investor reporting, according to A.M. Best's commentary. "ILS fund managers and market participants are increasingly discussing the significance of transparency to investors and standardized reporting," A.M. Best said. "It appears information provided to investors varies widely from manager to manager."

According to A.M. Best, those variations could include the following.

• Full PMLs versus PMLs at select return periods
• Distinguishing between perils that are well known from a modeling perspective and so-called secondary perils that may need to be "shoe-horned" into PMLs
• Differences in the way exposures are reported, such as whether by limits or by modeled losses
• The inclusion or exclusion of trapped collateral assumptions in modeling and performance fee determination
• The basis of the post-event loss estimation (some may provide losses to their specific portfolios of a particular event without stating the industry-wide losses they assume for that event, A.M. Best said)
• The time frame for reporting after a loss event
• Monthly versus quarterly reporting

"The clamoring for standardization of investor reporting tends to be loudest after significant loss events," the A.M. Best commentary said. "However, it appears that some investors may require more information from fund managers before deciding to re-enter the ILS market."

Finally, A.M. Best noted that as the ILS market continues to grow, there is a continued search for new, efficient ways to face ceding companies.

The ILS market continues to grow, evolve, and, no doubt, face new tests. One might come soon in the form of bonds sold by the World Bank in 2017 to help developing countries deal with a pandemic. Industry observers expect the COVID-19 outbreak to trigger the bonds, causing losses for bond investors.

If so, it will be the latest test for the ILS market, a market that has thus far navigated various tests successfully.

Bibliography

A.M. Best. "Insurance-Linked Securities Market Looks to Future after Servicing Record Cat Losses," March 9, 2020.

Gallin, Luke. "Catastrophe Bond and ILS Issuance on Track To Break Q1 Record," Artemis, March 6, 2020 (citing Artemis's "Catastrophe Bond and Insurance-Linked Securities Deal Directory").

World Bank. "World Bank Launches First-Ever Pandemic Bonds To Support $500 Million Pandemic Emergency Financing Facility," June 28, 2017.