ILS, on the way to normalization?

After the past few challenging years and despite significant natural catastrophes, the ILS market delivered a solid performance during 2019.


In 2019, the Swiss Re Cat Bond Index delivered a total return of 4.59% , compared to 2.53% in 2018, showing that repricing is starting to show its positive effects and that the loss creep of the 2017 and 2018 events have been fully absorbed.


Compared to other asset classes, the picture could be disappointing: the S&P 500 and high yield bonds returned 31.48% and 14.3% last year respectively.


The key argument in considering ILS is the diversification power of the asset class within a traditional investment strategy, but that’s not the only advantage.


The market has continued to grow in liquidity, especially on cat bonds, with USD 41B of outstanding (vs USD 25B five years ago) enabling to find bid-offer spreads of half a point, for a couple of million, on recently issued bonds.


Diversification within the asset class has also made progress. Climate change has brought awareness of a need for protection to non-wealthy people, or at least those who do not have access to insurance coverage. Policy makers are calling for a reduction of the protection gap as they anticipate increased damages stemming from climate-related natural catastrophes.


Some ILS players have started to propose alternative solutions to enable coverage. In partnership with certain countries, the World Bank organization is sponsoring several transactions with parametric or model-loss triggers. For example coverage linked to atmospheric pressure, earthquake magnitude, wind speed in countries like Mexico, Peru, Bolivia or Indonesia.


These structures could prove to be complex to model and usually onboard basis risk where the occurrence of an event could trigger the bond even if no actual economic losses were incurred. ILS managers should be very selective when analyzing transactions with high levels of modelling optimization. This opens the door to asymmetry of information between sponsors and investors and could lead to an underestimation of expected losses.


Nevertheless, maximizing diversification within the ILS market remains a priority, as risk concentration has always been one of the Achilles heels of the asset class. Most of the contribution to the expected loss of an ILS portfolio still comes from US hurricane/earthquake, European windstorm and Japanese typhoon/earthquake.


Adding new regions and/or perils enables investors to optimize the Value at Risk of the ILS portfolio and minimize its downside risk.


Valuation wise, improvement continued but at a slower pace. The coupon/EL ratio multiple of primary issuance has improved at 2.4x and is back to the 2015 level, though remaining far from the 10 year historical average of 2.9x. The dislocations, created by the outflows suffered by some retro and sidecar specialized funds, are starting to normalize and the hunt for yield phenomenon is again at play. Consequently, the offer/demand is starting to find a new equilibrium at a more attractive valuation level. This repricing has enabled most managers to de-risk their portfolios. These funds should now be more resilient to natural catastrophic events on a cumulative or per occurrence level.


Going forward, the low yield/spread environment in traditional markets should reinforce the call for cat-bonds. The US 10-year Treasury bond is now returning a yield to maturity below 2% and the US high yield is trading only at 355bps over Libor. By way of comparison, a typical cat bond is now trading in a 500/600bps Libor spread context and is not directly influenced by economic growth, the credit cycle or geopolitical events.


Climate change is a key long-term concern for the asset class but the short-term nature of the instruments (1 to 3 years) helps to adapt pricing and de-risk portfolios while new peril and/or regions enhance diversification and mitigate downside risk.



This article is an opinion article and does not constitute investment advice or recommendations. Neither the author nor SCOR Investment Partners assume any liability, direct or indirect, that may result from the use of information contained in this opinion article.



Chief Investment Officer, SCOR Investment Partners
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