Re-underwriting and de­­­-risking in the ILS market

The global insurance-linked securities (ILS) market remains saddled with prior catastrophe losses, a decline in assets under management (AUM) for some prominent ILS funds, and a drop in the overall performance of ILS funds despite another year of a record cat bond issuance.

Issues that were especially relevant for the reinsurance and ILS markets in 2021 include the following:

• Catastrophe losses in 2021 were the highest since the record high in 2017, with notable events including Hurricane Ida, Winter Storm Uri, the Bernd floods in Europe, and the December tornado outbreak in the US;
• Losses associated with secondary perils continue to receive increased attention from reinsurers and ILS managers due to their magnitude;
• COVID-19-related claims reserve trends are levelling off and stabilising;
• Increased catastrophe loss experience is driving the market to improve underwriting, tighten coverage language, and seek rate increases;
• The retro market remains challenged by capital constraints; and
• The poor performance of some ILS sectors contrasts with the positive performance of cat bonds.

The ILS market experienced the highest catastrophe losses since the record high in 2017. Munich Re estimates insurance industry losses from natural catastrophes in 2021 at $120 billion, and Swiss Re, at $112.3 billion (excluding the US tornado outbreak in December 2021) (Table 1). According to Swiss Re, insured losses in 2021 far exceeded the average of $86 billion losses the past 10 years.

Secondary perils such as wildfires, tornadoes, severe convective storms, and flooding account for a large share of the losses from catastrophe events from 2017 to 2021. These perils are generally small to medium-sized events or secondary events that follow a primary peril. The most common and destructive secondary events include hurricane-induced flooding, storm surges, hailstorms, and fires following an earthquake.

Other secondary perils, such as torrential rainfall, thunderstorms, drought, and wildfire, are considered independent events and are not always modelled.

In recent years, secondary perils have become a concern for the reinsurance and the ILS markets. Losses from secondary perils are now equalling or exceeding losses from primary perils. For example, Winter Storm Uri, the Bernd floods, and the December US tornado outbreak were considered secondary perils, with current losses estimated at approximately $32 billion, accounting for more than a quarter of 2021 insured losses.

There are some vendor models for several secondary perils (at least for US risks), but recent experience has demonstrated that these models need refinement. For example, much of the damage associated with Winter Storm Uri was related to the effect of the power outages, which were not necessarily taken into account in the loss modelling.

Some ILS managers adjust their vendor model results in an attempt to account for such perils by either (1) adding a load to the loss associated with the primary perils, or (2) using their internal model to estimate the losses from secondary perils. However, increasingly, some are tightening contract language to exclude such perils or placing loss limits to mitigate the impact on their loss figures.

COVID-19-related claims reserves continue to level off and stabilise. However, incurred but not reported (IBNR) losses remain a significant component of COVID-19 claims, so ILS managers are pushing back on what they perceive to be excessive trapped capital—in some cases, going through arbitration for resolution. ILS investors do not expect to cover business interruption claims resulting from COVID-19, as the intent of contracts was never to cover these events.

Coverage tightening and exclusions of communicable disease remained factors in January 2022 renewals, but price and attachment point increases have much greater impact on the negotiation process. In the UK, the business interruption cases due to the COVID-19 pandemic have tended to favour insureds, whereas in the US, pretrial rulings have tended to favour insurers—to date, the limited number of appellate court case rulings have affirmed the lower court rulings.

The substantial losses of recent years have made clear that rising rates are not enough to improve underwriting results for ILS managers and reinsurers. These losses have also led to a diminution of available capacity, particularly for aggregate reinsurance and retrocession. As a result, for the January 2022 renewals, the ILS and reinsurance industry focused negotiations on terms and conditions, restructuring coverage features such as adding per-event caps in aggregate covers and raising attachments and deductibles.

A report from Gallagher Re characterised the January 2022 renewal negotiations as “tense,” often involving senior management of reinsurers in capacity deployment decisions typically left to underwriters, making compromises on future pricing negotiations harder to reach.

Reinsurers were far less willing to assume risk in the low-attaching layers, forcing primary carriers to retain more risk on their balance sheets. This shift has led to de-risking throughout the value chain, and primary insurers are now more selective of their policies to avoid any significant risk concentrations.

Increased premium rates, higher retentions at the primary level, and stricter contract wordings are intended to better protect the ILS and reinsurance markets from the increased frequency and severity of events.

ILS managers generally operate in the remote layers, but protection buyers have a strong desire to seek coverage in the low-attaching layers. This mismatch in the supply and demand of capital has led to protection sellers receiving preferential treatment from reinsurance brokers if they are willing to provide coverage for lower-attaching layers. With sound re-underwriting and derisking, ILS managers are taking advantage of current market conditions to rebuild ILS portfolios, with the potential to deliver their target returns but with lower volatility.

Aggregate cover share has been down due to a shift in the risk appetite of protection sellers. Supply for aggregate cover has contracted and was more challenging to place than occurrence cover. Buyers had to retain more risk, and bought higher attachment points during the January 2022 renewals.

Aggregate retro capacity was particularly limited, especially for hurricane- and wildfire-exposed contracts. Aggregate retro capacity has been more difficult to source than occurrence retro capacity and remains in retreat in the US, after dominating the retro market in previous years.

However, buyers retained their appetite for aggregate retro cover at the January 2022 renewals. As in the broader industry, there was a move toward higher attachments and deductibles, as well as specific terms around how many events are required to trigger any payouts. Rates in the January 2022 renewals rose across the board for the retro and reinsurance segments, especially in loss-affected programmes, such as Germany, Belgium, and the nearby countries, which were affected by the devastating Bernd floods. Table 2 shows the various rate increases in selected regions.

The retro market remains one of the most capital-constrained and loss-affected sectors. Insurance industry experts estimate the retro market at $20 billion and believe the ILS market supplies about 50 percent of that capacity. The ongoing rate increases in the last few years reflect the underpriced retro cover and the difficulty of appropriately pricing to the level of risk.

The market faces a capacity problem for various reasons: elevated losses due to the increase in frequency and severity of catastrophe events, including secondary perils, since 2017; ILS trapped capital; and ILS investors’ diminished appetite for writing aggregate cover.

The retro market is constrained due to losses and to the challenges of raising capital because of such losses. For example, Markel Corporation wound down its retro manager, Lodgepine Capital Management, because of the difficulty of raising capital. In addition, during the January 2022 renewals, RenaissanceRe’s Upsilon retro vehicle offered less than half the limit than it did in 2021, reflecting the impact of losses and trapped capital. Overall, traditional retro players such as Aeolus, AlphaCat, and Lancashire experienced losses that have shrunk capacity.

The challenges related to capacity availability and the appetite for writing aggregate retro have left some buyers in a more difficult position. The January 2022 retro renewals saw numerous delays, even beyond those seen at recent renewals. This market has been bogged down by capacity problems from time to time because of loss events and underpricing. Not only has capacity contracted, but whatever capacity is available is shifting to more risk-remote layers. As a result, protection sellers’ appetite for a lower-attaching layer of excess of loss retro was limited.

Retro protection sellers focused on restructuring coverage features rather than prices. Protection buyers have either to restructure their retro programmes for the benefit of all or, if feasible, turn to soft retro cat bond programmes issued by reinsurers with industry-loss index covers as a lower-cost alternative.

Although retro buyers seeking this alternative to their usual indemnity retro covers leave themselves open to basis risk, taking on this risk is probably preferable to not having any coverage at all. Table 3 shows soft retro cat bonds issued from 2017 through 2021.

In 2021, issuance in the 144A cat bond market reached a record amount of approximately $12.5 billion, exceeding the previous annual record set in 2020 by almost $2 billion. There was great interest in cat bonds from the ILS investor community due to the relatively attractive return, liquidity, transparency, and contract certainty offered by cat bonds. Capital remained abundant to satisfy the rise in issuance of cat bonds and, in many cases, led to the upsizing of issues, and some deals pricing down.

Despite the strong inflows of new capital, investors were disciplined and clearly demanded appropriate risk-adjusted returns, establishing a floor on pricing. As a result, cat bond returns were reasonably stable in 2021. One metric ILS investors use to gauge the perceived risk/reward scenario is the loss multiple—the ratio of spread to expected loss. The spread is the compensation or premium to investors. The loss multiple has fluctuated from as high as 3.47x to as low as 2.06x during the past nine years.

Figure 1 shows the loss multiple from 2013 through 2021. It declined steadily from 2013 to 2017, when it bottomed out at 2.06x. It then rose over the next few years, peaking at 2.93x in 2020 due to substantial cat losses. In 2021, the loss multiple fell to 2.43x, the same as in 2015, driven mainly by high investor demand for cat bonds.