Insurance Linked Securities in 2019: Asking the Right Questions

The record losses we saw in 2017 and 2018 were felt heavily by the insurance industry, and there is no denying that two years of losses have affected investor sentiment. While such a statement is hardly surprising, it is notable that we’ve seen a marked difference in attitude between renewals at the end of 2018 versus the prior year. The more cavalier responses to the losses of 2017—which people viewed as a “one-off”—have certainly dampened the appetite of investors, who are now taking a more measured approach.

Within this new reality, it is worth highlighting that the archetypal investor is much broader today and increasingly part of larger asset allocators across many strategies and investments (equities, fixed income and so on). Of course, it is critical to remember that this asset class, by its nature, will see periodic losses.

Investors should view it over a five- or 10-year time horizon. In the short term, investors can see one or two years of losses, but over the longer investment period, they should still see attractive returns. However, two years of consecutive losses inevitably have driven more difficult questions from investment committees. In contrast you have a 10-year bull run in equities—and diversification hasn’t yet paid off.

Paresh Thakrar

So, what does this mean? Rather than a mass exodus, investors have become far more nuanced with regards to how they participate in the sector. Notably, they are interrogating the underlying risks far more carefully—retro or reinsurance, regional clients versus nationwide, average tenures of clients and more. They are also looking far more deeply at the layers and programs in which they participate. Investors ultimately are far more conscious of looking in detail about where they may experience losses. One result of this has been the shortage of retrocession capacity, which has been a feature of 2019 as ILS investors have pulled back from the class.

Ironically, two years of losses have finally given investors a true picture of performance differentials and underwriting quality across the market. The spread between the best and worst performers surprised a lot of investors in both 2017 and 2018—particularly those who believed that outperformance in ILS wasn’t available. Ultimately the relative track record of funds is speaking for itself.

Another important trend worth noting is the increasingly broad spectrum of investors in the class. Greater diversity of investors makes capital more fluid, which dampens excessive rate changes. This is a good thing for the stability and maturity of the asset class.

Appetite for Innovation

In terms of the risks themselves, it is certainly true that we see significant commentary around “new” and “growth” areas for third-party capital, such as casualty and cyber classes. In reality, while there is still experimentation taking place, some of this has been put on hold given the losses experienced in the property space. It is very much a back-to-basics year. People want good, solid underwriting without “unforced errors.”

There is still interest in diversifying risk in portfolios, but it is more measured versus a few years ago when people were asking, “When will you securitize cyber and turn it into ILS?” Today, there is far more focus on good fundamentals and incremental development of the portfolio.

What is really exciting, however, is what is happening at Lloyd’s.

Lloyd’s wants to establish itself as a center for ILS. If you combine this with the London ILS framework and the structures put in place there, you see real opportunity. If you find a way to bring capital easily into Lloyd’s, in the same way as Bermuda, that would be a real win. What differentiates London ILS is the combination of proximity to Lloyd’s and a critical mass of both investors and insurance risk being placed.

Questions Investors Should Ask

Taking this together, what questions should investors in the space be asking?

The most important thing they should be seeking is an ILS partner that offers good access to risk and to business. If they do not have the strong relationships with brokers and cedents in place, they will not be able to access the best risks at the right prices.

Evidence of this is the fact that virtually all the leading vehicles are under the roofs of well-established re/insurance businesses, so they will benefit from the investments in technology, infrastructure and data gained from years of operating in the market.

Within this, investors also should be insisting on proper governance around the risks they are taking on versus those staying within the re/insurers’ book. In many ways, it is similar to the proprietary trading desk and client trading desk at an investment bank. Alignment between manager and investor is really important. It resolves the age-old problem of negative selection. Firstly, investors should be looking for a vehicle that is part of a high-quality re/insurer. Secondly, they need to make sure the re/insurer has alignment mechanisms in place. In other words, it sends a powerful message when a re/insurance business writes the same risks on its balance sheet as it writes for ILS investors.

It is also important to look at more than the technical modeling outputs. While modeling is a critical input to the investment decision, there still remains a high degree of uncertainty around the outputs and numerous assumptions in those models.

It is as important to recognize the importance of investing in vehicles managed by underwriting businesses. Companies, which at their core think about things from an underwriting perspective, understand clients and conduct due diligence above and beyond the models. The best players take the output of the models and enhance this with human underwriting experience, claims, legal and contracts expertise and, of course, data.

Last but not least is the transparency and frequency of communications that investors should expect from their managers. ILS is a complex asset class, but it should never be a black box allocation. Good managers build trust through clear, transparent communications, whatever the performance environment.

Seizing the Opportunity

It’s clear that, despite several challenging years, the appetite from third-party capital remains strong as pricing continues to improve. However, it’s also true that investors are assessing the asset class in more detail. This is a welcome development. The opportunities for investors and high-quality players are compelling. It is up to investors to ask the right questions and us, as an industry, to give the right answers.

This article is republished from the September/October 2019 issue of Carrier Management, the publication for P/C insurance carrier C-suite executives.