The Intelligent Quarterly from the publishers of The Insurance Insider

Summer 2018

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Every cloud…

Fiona Robertson

Hurricanes Harvey, Irma and Maria (HIM) were not the nightmare event for insurance-linked securities (ILS) managers that some might have anticipated, but as the (re)insurance industry began totting up costs from the windstorms, concerns began to mount that some losses were going astray.

While industry losses from the full roster of natural catastrophes in the third quarter of 2017 were generally expected to range between $80bn and $100bn, the claims tally emerging from individual company results was initially perceived to be falling well short of this total.

Undoubtedly, some of the fear about the potential scale of alternative reinsurance market losses was due to the fact that there is less public visibility on the ILS market claims burden.

But a general consensus has begun to emerge that the ILS market could pick up as much as 25 percent of total industry claims, a figure cited by AM Best chief rating officer Stefan Holzberger during a November conference hosted by the ratings agency.

Where ILS losses fell
Hurricane risk is the ILS market's greatest area of exposure - but Harvey, Irma and Maria all presented such different challenges that they impacted ILS managers in an uneven way.

Retrocession specialists bore the brunt of the losses as the aggregation of claims mounted, while the cat bond market escaped relatively lightly.

Click to enlarge This also contributed to the opacity over ILS losses - as the cat bond sector is the more public part of the market, while retro writers sit at the end of the risk transfer chain and may have difficulty establishing their losses as they flow through the market.

As much as half the ILS market's claims could be related to retro losses, said Hannover Re's managing director of retrocession and capital markets Henning Ludolphs, speaking alongside Holzberger at the AM Best conference.

This suggests a figure of around $10bn - an estimate corroborated at a Florida event by Aon Benfield president Andy Marcell, who said his firm had tracked around $20bn of impacted retro limit, with around $9bn of collateral affected.

Collateralised reinsurance losses will have varied by the risk level of individual strategies, but the average recorded by the ILS Advisers index, which tracks 34 funds, came to a 9 percent loss in September. The year-to-date result for the first 10 months was a 6.91 percent drop.

In 2011, the only other year it was negative, the ILS Advisers index posted a 0.14 percent annual loss.

At the other end of the scale, cat bond instruments are largely designed to respond to notably large single events, not the kind of mid-level hurricanes that Harvey and Irma were in terms of insured losses.

Click to enlarge The Swiss Re global cat bond price return index was down 5.4 percent over the course of September and October - suggesting a writedown of around $1.25bn to the roughly $25bn market.

Many of these losses would have been unrealised mark-to-market writedowns, although some small Florida bonds and high-risk annual aggregate deals were expected to respond to claims.

However, it was not one of the three major hurricanes but rather a Mexican earthquake that triggered the cat bond market's first and largest confirmed loss from the 2017 catastrophe activity, through the $150mn World Bank parametric deal for Fonden.

This is the cat bond market's largest single payment since the 2011 Tohoku earthquake, which triggered a $300mn cat bond payout.

In the industry loss warranty (ILW) market, the Micrix ILW index fell 12 percent after the September hurricanes - indicative of around a $720mn loss in a $5bn-$7bn overall market.

However, the index does not track the performance of any aggregate ILW triggers and is globally diversified, so actual ILW losses would be expected to be somewhat higher than this, as the market is heavily geared to the US and includes some aggregate cover.

The bulk of the ILS market's losses will be in reinsurance and retrocession, with more exposure to Irma (as it falls in their hotspot of Florida exposure) than to Maria, where traditional market share is higher and exposure would be mostly via retro or sidecars.

But with some ILS managers building up insurance books in recent years, they will also share "a small but not insignificant portion" of primary market losses, according to Willis Towers Watson Securities' head of ILS Bill Dubinsky.

"It is still far too early to close the book on the exact allocation of losses among insurers and reinsurers, let alone between traditional balance sheets and ILS," he says.

Moreover, JLT Capital Markets co-heads of ILS Michael Popkin and Rick Miller point out that the issue of trapped collateral complicates the ILS market's exposure. This concerns capital that is not expected to be a loss currently, but which is being held over by a buyer in case claims rise to trigger a contract.

Equally, just as traditional reinsurers have bought retro to reduce their net losses from HIM, ILS managers have also hedged their portfolios.

"Thinking about how ILWs might have played into all of this could make one investor seem more exposed on the surface, but very well hedged beneath the surface," Popkin says.

2017 loss experience
This year's hurricanes have come after a run of favourable years for the (re)insurance markets. So were ILS investors prepared for losses such as these?

While this year's losses may have been extensive, cat bond specialist and Fermat Capital Management co-founder and managing director John Seo says he ranks the 2017 events in only fourth place behind 1992, 2005 and 2011 in terms of their market impact.

This takes into account the "surprise factor" of losses as well as the impact on capital levels, rather than just nominal loss totals.

"The losses this year are big enough to check an investor's commitment, but not big enough to shake an investor's faith," Seo adds.

Cat bond losses have been in line with modelled risk profiles, but Seo highlights that the return period of major losses depends greatly on their definition and scope.

So while some are talking about a 1-in-40-year loss experience, Seo argues that this year's cat bond market losses are modelling as closer to a 1-in-10-year aggregate loss.

"If we put 2017 alongside 1992, 2005 and 2011, we would be seeing four similar or greater loss years across three decades."

That said, the 2017 loss experience has primarily highlighted where the ILS market's pockets of aggregate exposure lie - and the extent to which some retro strategies are far more exposed to a 1-in-10-year aggregate loss than they are to a 1-in-100-year single hurricane.

"This was primarily a retro event," Seo says. "Retro events should be expected to happen every three to eight years."

At more of a micro level, Willis Towers Watson's Dubinsky highlights loss adjustment expenses as a possible exception to the general rule that investors have not materially changed their view on risk following the 2017 events.

As Harvey and Irma followed each other in quick succession, Florida carriers faced difficulties in recruiting loss adjusters, which put expenses well ahead of the usual assumptions.

"Traditional contracts bore the full brunt of the some of the adjuster shortages but factor-based contracts such as the [Florida Hurricane Catastrophe Fund] and reinsurance backed by cat bonds did not," Dubinsky explains.

Post-loss reloading
The 2017 hurricane season has kept everyone in the reinsurance market busy, but spare a thought for ILS managers juggling multiple challenges in the run-up to the 1 January renewals.

Not only do they need to accurately assess losses and communicate with reinsurance buyers about their expectations for renewals, they also have to figure out what kind of post-event pricing opportunity might be available and communicate with their investors to raise fresh capital to replace lost and trapped collateral.

Mother Nature was on their side, in that the hurricane losses occurred midway through the season, giving ILS managers at least a couple of months to accomplish this ahead of 1 January.

Speaking in late November, Dubinsky says that most investors seem reasonably well positioned to trade forward.

Indeed, he suggests that some managers may even use the 2018 renewals as an opportunity to "grab market share intelligently both from traditional reinsurers and from other investors".

"This shift will only occur if incumbents push price and give investor newcomers the opportunity to do so, whether in cat bond form or in private transactions," he notes.

Some ILS managers had waiting lists for new investors before these events and pointed to this pent-up demand as a factor that would assist with reloading their capital.

Moreover, this year's activity has drawn interest from investors that have been sitting on the sidelines of the market, commentators observe.

When it looked like Hurricane Irma was going to hit Miami, Andre Perez, CEO of ILS service provider Horseshoe, said the firm was involved in preliminary fundraising talks that could have brought in $3bn of capital over the course of just two days.

"We're seeing investors coming back, who haven't been back since post-KRW [Katrina, Rita, Wilma]," Perez said at the October Trading Risk New York conference. "I think it is a great opportunity for ILS funds to raise more capital."

But as Irma drifted clear of Miami and it became clear that the HIM losses would be highly manageable for the reinsurance market, the issue of how much of a ratings reaction would follow raised a question over whether opportunistic investors would be willing to move back into the market.

The yield question
Ultimately, the key question for investors considering their ILS strategy for 2018 will be how much additional compensation they can expect to earn post-loss.

But as alternative reinsurance capacity now plays such a significant role in the catastrophe reinsurance segment, the overall reaction is expected to be far more subdued and controlled than after the capital shock loss of Hurricane Katrina, for example.

JLT Re North America CEO Ed Hochberg says the firm is expecting the diversity of capital sources available to buyers to have a "dampening" effect on the pricing cycle, but notes that the impact will not be uniform.

"Some parts of the market will see more price adjustments (i.e. loss-affected programmes) than other segments and the persistency will not be the same everywhere," he says.

Ultimately, given that the cat bond market rebounded quickly from the 2017 losses, Seo is expecting this market segment to attract new strategic sponsors as a result.

This is being influenced by reinsurance buyers shifting their emphasis away from obtaining annual rate decreases towards rate stability, he explains, with the cat bond market offering multi-year cover that can smooth out the impact of losses.

"We should expect next year to be yet another record issuance year in the cat bond market," Seo forecasts.

For the alternative sector at least, there has proved to be a silver lining in the clouds of this year's hurricane losses.

This article was published as part of issue Winter 2017

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