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ILS investing: Hopes rise that diversification pitch is gaining traction

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Ahead of Storm Ian, ILS firms were signalling a generally optimistic outlook regarding inflows in Q4 and into next year, with the hope that a spike in enquiries coming from allocators in the past few weeks will translate into new mandates for ILS.

One manager confirmed at least one new investor had committed funds, while others suggest different types of capital are reconsidering the sector either with a fresh focus on diversification or with an eye on distressed higher-return market segments.

However, other managers are counselling “cautious optimism”, arguing that an active scene for enquiries from new investors doesn’t necessarily mean immediate high levels of fresh inflows.

The more cautious point to the thorough but slow-moving investment decision-making processes employed by institutional investment houses.

While Storm Ian may throw a new inflection on future fundraising conversations, many of these long-term general dynamics remain in play, but with differences in opinion amongst ILS managers on how they will play out.

Turbulence in the wider financial markets during the year led to sharp devaluations in equity holdings, and bonds suffered mark-to-market losses. Funds that already had reached the full extent of their ILS target became overweight ILS.

In this context, some ILS firms reference a “rigorous” asset sell-off by investors looking to maintain portfolio balancing, including trimming back ILS where this was needed to stay within target.

Others argue that the change in market dynamics and the ensuing portfolio balancing issues contributed to a subtle shift in investors’ perception of ILS for the better. The Financial Times reported on how 2022 was shaping up as the year when investors were reminded of the importance of diversification, with Invesco advocating a shift from a 60/40 split equities to bonds, to 50/30/20 equites, bonds, alternatives.

Managers describe ILS as having been viewed in the past as a “satellite alternative”, a kind of adjunct to “core” or “traditional alternatives”.

Certain managers argue that, as wider market conditions roiled this year, and in some cases traditional alternatives were negatively impacted by events – such as the shock on commodities of the Ukraine conflict – ILS became more established in investors’ minds as a core alternative.

We’re starting to see teeth in the strategic alts discussions

This development comes arguably as a hastening or way-marker on a longer-term journey that has seen ILS earn its diversification spurs over time.

“It has done what it said on the tin for a long period of a time,” said a source.

Investors are “thinking more strategically about what they want to be holding over the next six to 12 months”, added another.

“We’re starting to see teeth in the strategic alts discussions.”

Cat bonds, in particular, have made a strong showing, having been more protected in general from losses incurred over 2017-2021. However, poor-performing strategies and frequency losses have dragged down the five-year record for some funds and the industry index as a whole.

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This nuanced shift in sentiment toward ILS from existing investors could in some cases lead to additional allocations, albeit likely not huge extra sums.

Widening spreads on cat bonds and the improved rate environment for cat risk generally is also helping.

“The stars are aligning,” said one source.

Exiting capital now cleared

Managers also described differing attitudes to ILS between investor types.

Investors that have held ILS since 2012 or earlier were in general staying the course, having experienced the upsides of the insurance market cycle as well as the downsides. Those that had allocated in time to experience the more heavily loss-hit years of 2016, 2017 and 2018 were more likely either to be holding stable or exiting.

The quitters tended to be those that had allocated to funds that had “not made it through”, or had turned in a poor performance over the past five years.

“For the most part, that [exiting capital] has now cleared its way out of the market,” said a source.

A third group of investors, typically covering more opportunistic capital associated with endowments, foundations or hedge funds, are now said to be looking at a return to ILS, attracted by strong pricing and clarity in terms and conditions.

This group includes investors that entered the market in 2006, following Katrina, Wilma, Rita, and then exited again in the early 2010s.

However, the general optimism for ILS is tempered by other challenging dynamics in capital markets and insurance markets generally. Pessimism factors include the impacts of a strong dollar on capacity coming from Europe or Japan. Also, inflation has served up a major challenge to insurance pricing, sharpening even further the edge on questions over how well investors are being compensated for the risk they are taking.

One source suggested that market players tended to be too wrapped up in their own world view to be able to see clearly how ILS really looks from an investors’ point of view – echoing comments reported by sister publication Inside P&C from the Monte Carlo Rendez-Vous.

“Cedants and market players live too much within our own world, believing investors can turn on the taps as soon as there is movement in ILS [pricing]. Market participants overestimate the liquidity of inflows.”

Delayed benefits

The consensus expectation for Q4 and 2022 as a whole, and through the 1 January renewal, is for the ILS market to remain stable or grow by a small amount.

The more interesting times for inflows could potentially come a little later, if they do – that is, at 1 June 2023 and into 2024.

After recent loss years, much still rides on improving average returns as well as the diversification pitch.

“The ideal would be a clear year in 2022, a clear year 2023, some moderation in financial markets, with them recovering a little bit, and investors still being reminded of the diversification benefit,” one said, echoing comments from HSCM co-founder Michael Millette during Monte Carlo that a couple of “ragged renewals” might be needed to encourage more capital back to the market.

The anticipated increase in demand for reinsurance at 1 January and beyond, including from new cedants, is expected to outpace supply, with that dynamic considered positive for ILS in that it ought to drive up spreads.

The unfolding events of the Atlantic hurricane season were also playing on managers’ minds. The season brings potentially increased demand, owing to uncertainty, and at the same time could prompt investors to hit the pause button.

“I do think there is a lot riding on the hurricane season,” one said. “If we can eke out a low-loss year, rates are so attractive, there has never been a better time to enter.”

The looming Storm Ian will throw an additional question mark into all these dynamics.

So, while some are talking up market prospects, with the potential for fresh and/or additional capital to flow into ILS during Q4 and at 1 January, others are eyeing a longer time horizon. They view the outlook with the expectation that market growth could be more moderate over 1 January, but with the potential to gain momentum through the middle to end of next year.