NEWS
ILS can solve property-cat gap
ILS investors can fill the void in property-cat capacity: Lohmann of Schroders.
The current market conditions represent an ideal opportunity for insurance-linked securities (ILS) investors to take on more cat risk, filling a gap left by traditional reinsurers backing away from the inherent volatility in the line of business, Dirk Lohmann, chairman of the ILS business of Schroders Capital, told Monte Carlo Today.
Lohmann explained that a mixture of factors has made investors and traditional reinsurers wary of property cat business. A number of unexpected losses in recent years combined with the uncertain impact of climate change have raised questions about the validity of the risk models and the way this business is priced.
In addition to this, volatility on the investment side of traditional reinsurers’ balance sheet has made them less willing to accept volatility in their underwriting. “That means their tolerance for volatility on the other side of the balance sheet is reduced,” he said.
“In contrast, for capital markets investors, this will represent only a small percentage of their portfolio, so they can manage that volatility. Plus, it is well paid and offers diversification, something investors are appreciating amid wider volatility in the capital markets.
“When you are looking at peak perils such as earthquake and hurricane risk, the capital markets can offer the most efficient way of taking that risk.”
Despite this, Lohmann describes sentiment among ILS investors at the moment as “nuanced”. He concedes that, following some heavy losses for the sector in the past five years, there is an element of “investor fatigue”.
In addition, he notes, large pension funds, some of the biggest investors in this sector, can take a time to determine and execute new strategic aims. “Some did their last review of this sector a year ago—before current market conditions, which have improved a lot,” he said.
Investor appetite is growing overall, he believes. “We are seeing some new investors looking at this space as well as existing investors looking to increase allocations. The sector is nicely teed up to post a record performance.
“There is always an education process required, especially around climate change.”
Dirk Lohmann, Schroders Capital
“The results will come through. There is always an education process required, especially around climate change, but the sentiment is positive.”
One part of this education, he noted, is around what realistic returns investors can expect from this asset class. Even though returns can be very healthy, he believes that education is important so that they understand what drives the returns and what they might need to do to increase them.
In a report titled “What are the realistic long-term return expectations for ILS”, authored by Lohmann and published on August 26, he notes that the novel nature of ILS means investors often put it into their “alternatives” investment bucket. This, in turn, brings certain return expectations, which can be misleading to investors, the report notes.
To offer context, the report cites the typical return targets of traditional reinsurers, which typically target returns on equity of between 700 and 900 basis points over a given “risk-free” benchmark.
In fact, this is roughly what the sector has achieved, according to research cited in the report. “The universe of perils insured is indeed dominated by US hurricane (peak risk) but also contains some diversifying perils at lower yields. Factoring those in, one would assume the resulting performance might be close to the lower end of the 700 to 900 basis points range cited above, and it has been,” the report notes.
Investors can achieve better returns, he notes, by positioning their portfolios more aggressively in the hope that no major losses occur or by using financial or structural leverage to boost returns.
But these strategies come with risks, he notes. The report summarises: “Achieving higher returns is possible, but at the cost of increased risk. The ultimate return derived is a function of the investor’s risk appetite and tolerance for large drawdowns.”
Main image: Shutterstock / fran_kie
