With natural disasters on the rise, Darren Trott looks at insurance-linked securities and how they are helping to support recovery from catastrophe
Reinsurance is an important risk management method for insurers. Over the years, insurance companies have used catastrophe (cat) bonds – a subset of insurance-linked securities (ILS) – to transfer insurance risks to capital markets, transforming these bonds into valuable risk management and investment tools by integrating pieces from reinsurance and debt capital markets.
Both ILS and traditional reinsurance markets increase the supply of capital available to the insurance industry. ILS funds can invest in a diversified portfolio of reinsurance products, as well as insurance-linked instruments (such as cat bonds).
ILS has grown in popularity and had a major influence on market prices, terms and conditions. For example, cat bonds are multi-year agreements and traditional reinsurers have therefore adapted to stay competitive, with many offering similar multi-year capacity for insurers that prefer the stability.
Recent natural disasters demonstrate ILS’s rising value to the global (re)insurance market. In the US, only 20% of households affected by Hurricane Harvey flooding in 2017 had flood insurance; the hurricane incurred losses of US$95bn, of which only US$30m were insured. This shows the variance between the (re)insurance industry’s capital, and insured losses. Not only did ILS survive through the Hurricane Harvey losses, it also displayed its potential to become an established class for investors. ILS market capital was therefore maintained or increased.
Other perils addressed by cat bonds and ILS have included named storms in North America and the Caribbean, US tropical cyclones, wildfires, volcanic eruptions and earthquakes. These perils have been dominated by cat risk: insurance news service Artemis found that in Q4 2022, approximately 34% of new issuances (US$535m) addressed North American earthquake risk, with another US$32.5m focusing on earthquake risk in China.
ILS capital has also become important in reinsurance purchasing. According to Aon, the property cat bond market is supported by new and repeat (re)insurance sponsors, and has maintained its popularity despite obstacles such as 2022’s Hurricane Ian, war in Ukraine and concerns around inflation and interest rates. As more (re)insurers look to the cat bond market to alleviate traditional reinsurance challenges, a mismatch in supply and demand has arisen. This, on top of increased catastrophe activity, means the market will present ILS investors with opportunities in 2023, driving further growth.
Ultimately, the ILS market has become a popular investment avenue because it allows investors to hedge and outperform competing markets. It survived the test of 2017’s high level of catastrophe losses and, while the cat bond market fell by about 9% after Hurricane Ian, some bonds did not face any losses in 2022, leading to the recovery of significant value. Cat bond and ILS exposure to Hurricane Ian loss development has so far been favourable and provided another example of the strong condition of cat bond investment, which survived major catastrophe loss in the peak peril region of Florida. According to an Artemis report, the outstanding cat bond market size reached a new year-end high of US$37.9bn in 2022 – a US$2bn increase on 2021.
ILS reduces the financial burden of recovery and rebuild, which is shouldered by governments, companies and individuals. As well as helping to close the gap between insurance needs and available capital, ILS investors can have a beneficial impact on people’s lives. A broader array of products is now being offered in the ILS market, and this is set to continue, with other classes of business appearing.
Despite the impact of Hurricane Ian causing some losses to ILS investment, ILS and the capital it attracts from other markets seem to be here to stay. However, the true test will be whether capital continues to flow into the ILS market to the mutual benefit of cedants and insureds. As this market continues to mature, the industry can look forward to more growth – and interesting developments that will offer more opportunities.
Darren Trott, 27, is studying for his first actuarial exam and works for KPMG in Bermuda
Image credit | Simon Scarsbrook