The $90 billion insurance-linked securities (ILS) sector is undergoing a sea change, led by investors with significant experience in the industry and a heightened awareness of the need to marry their desire for non-correlated risk and attractive returns with the growing demand for responsible investment.
Executive SummaryThe $90 billion insurance-linked securities sector is being led by a new breed of ILS investors who are looking beyond cat risk for high-frequency, low-severity investment opportunities and are increasingly guided by a commitment to ESG precepts, according to Matthew Charleson of Strategic Risk Solutions, who also says this generation of investors is increasingly engaged with InsurTech.
For most of the last 20 years, traditional ILS investors have been hedge funds, pension funds and other institutional investors. They look to the insurance and reinsurance sector for portfolio diversification as an alternative, non-correlating asset class that produces historically strong returns.
The more traditional appetite for ILS had been high-severity, low-frequency events with a short duration. Natural catastrophe perils, which until 2017 made consistently positive returns (for the most part), were a compelling investment target.
Three consecutive years (2017-2019) of severe cat losses up-ended ILS, trapping capital that became extremely inefficient and unable to put to work. This isn’t what the traditional investors were looking for and not what they had come to expect from prior performance.
This dynamic prompts two interesting questions. First, what is to be done with that trapped capital? And second, as consistently poor performance wasn’t originally expected, what other risks exist that can be reliably modeled so that the expectation of investors can be better met?
While some ILS investors fled for less risky vehicles, many others have become sophisticated players who continue to believe in the insurance sector as an attractive investment option with non-correlated risk and stable returns. They’ve also expanded their horizons as far as industry partners and investment vehicles are concerned.
Fitch Ratings, in a report published in early June, noted that with investors exposed to the volatility experienced across traditional capital market assets in 2020, “the relative stability of catastrophe bond investments remained attractive throughout 2020, [leading] to a heightened focus for capital inflows into the ILS market into 2021.” (Source: “U.S. Hurricane Season 2021: A Desk Reference for Insurance Investors,” Fitch Ratings, June 1, 2021)
“Perceived benefits of catastrophe bonds’ higher liquidity profile and peril-specific coverage relative to other ILS instruments (sidecars, collateralized reinsurance) are promoting expanded near-term activity,” Fitch said.
New risks for today’s ILS investor to consider include flipping the script—with the right, non-correlated lines of business—from high-severity, low-frequency to low-severity, high-frequency.
While no specific line seems too oblique, nonstandard auto, operational risk and intellectual property coverage are some particular areas that have made headlines in bringing new ILS products to market.
As they continue to apply their deeper understanding of the insurance sector to their investment choices, ILS investors are also determining how environmental, social and governance (ESG) principles are impacting investment options. In this regard, they’re looking for sustainable, impactful investment opportunities as well as an attractive yield for short- to medium-term risk in the continuing low-interest-rate environment.
The opportunities represented in ESG investments are huge. In 2020, PwC forecast that by 2025, almost 60 percent of the assets of European mutual funds (nearly $9 trillion) will be held in ESG funds. Seventy-seven percent of EU institutional investors surveyed by PwC plan to stop buying non-ESG products in the next two years.
Aside from tightened regulatory and policy requirements in Europe, there are two drivers in creating an ILS/ESG alignment: One is a new generation of investors and industry professionals who have put ESG issues on the front burner. The other is the manner in which insurance underwriting expertise can enable financial resilience and recovery. This expertise is enhanced by the increasing sophistication of the InsurTech sector.
With these two drivers, ILS is becoming a conduit between ESG-conscious third-party capital and the insurance industry, amplifying the impact of risk modeling expertise that’s backed by deep financial investment and supported by sophisticated analytics.
A key area where this relationship can become a real win-win is in the ever-widening protection gap—the gap between economic and uninsured losses.
Data-driven solutions like parametric or index-based covers, one of the many products developed for weather-linked or natural catastrophe risks, could be instrumental in helping to close the protection gap and can be conceptually adopted to non-natural peril risks with the help of developing technologies and expansion in the InsurTech sector.
Here again, the opportunity is huge. According to a June 2021 report issued by Swiss Re Institute, the global protection gap hit a record $1.4 trillion in 2020, worsened by the impact of COVID-19 as well as natural disasters and exposure related to climate change. The report said that resilience against natural catastrophes remains lowest with a protection gap of more than $230 billion in 2020, noting that 76 percent of global nat-cat exposures remain unprotected.
It’s doubtful that those involved in the early development of ILS anticipated the impact the sector could have on the sustainability of the insurance industry and the resilience of the world’s economies. Today’s ILS investor has a clear line of sight on both and will no doubt play an increasingly important role.