Investors in insurance-linked securities are leaning toward structured catastrophe bonds rather than broader ILS instruments to steer away from unexpected losses from secondary perils, experts speaking at recent Rendez-Vous conferences agreed.

In addition, one analyst speaking at Munich Re’s Roundtable earlier this month observed that while cat bond investors are accepting lower yields than they did two years ago, investors in reinsurance stocks are demanding higher returns.

“There’s a disconnect,” said Andrew Ritchie, founding partner of Autonomous Research, an independent equity and credit research firm. “My observation of the last 12 months is a dramatic spread between expected returns between parts of the ILS market, particularly cat bonds, and expected returns, or the cost of equity, that the market is demanding of listed reinsurers.”

“By my calculations, since 2019, new issue cat bond yields, on average, are down 200 basis points. The implied cost of equity, judging from the price-to-book, or the P/E [ratios] of listed reinsurers over the same period, is up about 200 basis points,” he said. Ritchie suspects that beyond a general divergence between the equity and bond markets, the differences specific to the reinsurance space also reflects investors’ negative views on reinsurers’ ability to deal with loss frequency—specifically, the degree to which the reinsurance industry can “get on top of so called secondary perils.”

“Those are clearly impacting lower parts of the capital structure, the listed reinsurers, whereas the cat bond market is sailing on regardless,” he said, attempting to explain the disconnect “between the implied cost of equity of a listed reinsurance sector and the apparently very low cat bond new issue yields.”

Ritchie spoke after several speakers provided a state of the ILS market overview: Munich Re’s Stefan Golling, member of the board of management responsible for global clients in North America; Cory Anger, managing director at GC Securities; and Stephan Ruoff, head of ILS at Schroder Secquaero.

Golling observed that the overall ILS market is very stable. “When it comes to the capacity, I would say we see a steady slight growth, certainly no drawback…On the other hand, [there is] also not necessarily a flood of new capacity.”

“We see a disciplined alternative market, as we have seen on the reinsurance side—maybe in some segments a bit more aggressive, a bit more optimistic, especially on the cat bond side,” he said.

Anger, describing three “sleeves” of the ILS market—cat bonds, collateralized reinsurance and sidecars—said there has been a greater appetite for cat bonds following a period of losses between 2017 and 2020. That period followed several years of low overall worldwide insurance and reinsurance losses between 2014 and 2017, when “many capital providers took on more risk in order to get better returns for the profile.”

“The cat bond market is benefiting from that,” she said. “What we saw over the second half of 2020 and into 2021 is an acceleration of capital coming into the cat bond space.”

Anger also noted that a high level of maturing ILS transactions in 2020 and 2021, which had been put in place between 2017 and 2018, has been redeployed into the cat bond market.

Ruoff referred to a bifurcation of the ILS market. “On the one side, we’ve seen the cat bond space really thriving, and with that, obviously, we’re also seeing spreads coming down to some extent. That goes in contrast to the private transaction side where we have seen probably the opposite,” he said, stating that inflows for the other ILS instruments has been slow, with spreads “increasing in line with the wider reinsurance or risk transfer markets.”

‘Worthy Strategy’

A few days after the Munich Re event, Fitch Ratings published a report, “Insurance-Linked Securities: A Year In Review,” revealing a record year for natural catastrophe bonds in 2020. Issuance reached an all-time high of $11 billion in 2020, beating the previous record of $10 billion set in 2017. Fitch anticipates that 2021 will come in even higher, the report said, noting that issuance reached $8.5 billion in just the first half. Reinforcing Anger’s observations, the Fitch report also noted that investors rotated slightly out of collateralized reinsurance into the catastrophe bond market, which offers more liquidity and structure.

Reviewing the recent performance of cat bonds for sponsors and investors, Fitch reported that over $650 million in cat bond maturities were paid to sponsors for cumulative losses of prior year catastrophes events in 2020—a figure representing 7 percent of all 2020 cat bond maturities. “In other words, investors received 93 percent of their invested proceeds.”

“Compared with the total amount outstanding, those claim losses were around 2 percent,” Fitch said.

Overall, alternative reinsurance capital at June 30, 2021 stood at $97 billion, and hovered around $95 billion in each of the three prior full years, the report said, citing information from Aon. Since 2011, however, alternative capital has grown nearly 250 percent, while traditional grew just over 30 percent $563 billion.

Earlier this month, during a renewal season briefing hosted by Aon, Mike Van Slooten, head of Business Intelligence for Aon Reinsurance Solutions, pointing out the $3 billion increase in alternative capital from year-end 2020 to the $97 billion at the end of June this year, said there has been a particular strong interest for property cat bonds, with the second quarter marking the fourth consecutive quarter of increased issuance.

Tim Ronda, Global Geographic Leader overseeing Aon Reinsurance Solutions’ regional capabilities worldwide, said, “Capital continues to believe that investing in insurance and reinsurance weather-related risk as an uncorrelated asset class has proven to be a worthy strategy, and is one that more capital and more investors are going to see increase as a part of their overall portfolios.” (Editor’s Note: Ronda left Aon to join TigerRisk as president a few weeks after the Aon event.)

“While some of the secondary perils around the world that may not be as modeled, [or that may not] have as much of a catalogue of modeling as cyclone and earthquake, have presented some issues to insurance companies’ earnings the last several years, many of the investors in cat bonds have found it to be a very profitable asset class, and one in which they’re excited about doing more of.”

“Obviously, there’s been a frequency of activity from secondary perils and some smaller storms. That’s led to a little bit of a challenge addressing a view of risk in the modeling at the lower end of a cat curve, and on an aggregate basis,” Ronda said. He added, however, that Aon believes “there are some really sophisticated firms putting a lot of effort into understanding that risk right now—and ultimately, we believe that capital will flow into that segment as well.”

“The supply and demand in the market is such that it’s going to be attractive market for people who aren’t rated reinsurers to continue to find ways to create value for themselves by putting more capital at risk on behalf of our clients,” he said, concluding, “We very much believe that this trend of increased capacity in ILS will continue.”

Investor Frustration

At the later Munich Re event, it was Ritchie’s observation about lagging reinsurer returns that caught the attention of viewers submitting questions, which were read to the panel by Andreas Müller, Head of Origination, Corporate Retro and ILS Investments at Munich Re. “The ILS and reinsurance industry have not met their cost of capital for five years in a row—and won’t do so in 2021,” Müller said, reading the preface to the first audience question aloud. “How long do you think the underlying investors continue to tolerate such underperformance? What needs to happen to provide comfort to investors, that capital managers understand the risks they write, and their broader fiduciary duties to investors?”

“There is a view that there’s a lot of talk about better pricing, better discipline, but unfortunately, those normalized earnings never happen.”

“It looks like 2021 will be the fifth year of above average losses, and investors are doing a serious rethink as to what degree reinsurers are really pricing for some of those frequency issues. There’s been a lot of talk about moving up the risk curve, moving away from volatility, curtailing capacity to aggregate covers, but there’s not a lot of evidence of it yet in delivery of improved returns.”

“So, the simple answer [is], the listed reinsurance industry needs to deliver several years of decent returns [and] show that they’re really, particularly, getting ahead of this frequency issue.”

Golling said that the reinsurance industry itself “cannot be happy with the returns achieved over a longer period in recent years,” but that he is optimistic about better returns in the future. “What makes me positive is that, maybe for the first time [in] many years, I really see a lot of discipline in the markets. First of all, on the primary insurance side, it’s maybe for the first time that the primary insurance market reacted and worked on terms and conditions and prices before the reinsurance markets. [They] were not just only pushed by increased reinsurance prices.”

He added that the uncertainty that COVID introduced had the effect of keeping discipline in both markets.

“Investor expectations, your own expectation is understood and shared by the reinsurance market,” Golling told Ritchie. “But we should also not forget, our business is volatile, and that’s also why we’re here. We don’t want to shy away from volatility,” he added. “It will happen again and again—that while you’re on a good track, there will be a quarter where the earth is shaking, the wind is blowing, or something else will happen.”