ILS market to bifurcate as more capital rotates into cat bonds: Swiss Re

The market for alternative reinsurance capital and insurance-linked securities (ILS) is set to bifurcate, as investor preference sees more capital rotating into catastrophe bonds in search of more stable performance, Swiss Re believes.

The company announced in Monte Carlo a new non-life insurance market study from the Swiss Re Institute, in which it proclaims that the alternative capital market in reinsurance “may not turn the underwriting cycle yet.”

Alternative capital, largely in ILS formats such as cat bonds through to collateralized reinsurance, “has become the main source of swing capacity in the property cat re/insurance market,” the Swiss Re Institute believes.

Similar to the wider P&C reinsurance sector, the ILS market and alternative capital has seen a re-pricing of risk, but this alone is not set to be sufficient to drive the influx of capital required to turn the current underwriting cycle, Swiss Re suggests.

While returns are significantly higher now, thanks to harder reinsurance pricing and elevated interest rates that ILS investments float on top of, Swiss Re notes that, “investor sentiment is lagging and there have not been significant investment inflows so far into this hard market.”

“This is partly because investors in lower-layer indemnity-based AC structures (ie collateralised reinsurance), have suffered unanticipated (and unmodeled) loss exposures since 2017, and loss creep for certain large natural catastrophe events,” Swiss Re explains.

Adding to this, Swiss Re also highlights that, “Some investors have exceeded their target allocation to insurance-linked securities (ILS) due to the outperformance of cat bonds relative to other fixed income assets, and must now reduce their holdings.”

In fact, the Swiss Re Institute estimates that, adjusted for inflation, alternative capital in reinsurance remains at the same level seen back in 2015 now, as the ILS market has not grown and so its capital base has effectively shrunk, in proportional terms.

“In the medium term, we expect incumbent investors to increase ILS holdings in line with assets under management,” Swiss Re said.

Because of the performance issues with some private ILS and collateralized reinsurance or retrocession investment strategies, Swiss Re believes we’ll see continued preference for catastrophe bonds from the investor base.

“We expect the AC market to bifurcate as investors exit underperforming segments and more capital rotates into cat bonds. Cat bonds have a solid track record despite recent high catastrophe losses.

“Based on floating rate collateral, they were not exposed to valuation losses from rising interest rates. We see long-term growth in the cat bond market, providing capacity for peak layers where the business model is attractive,” the Swiss Re Institute said.

While cat bond capacity is estimated to have grown at 3% annually for the past seven years, Swiss Re says that “This fell short of the global growth of natural catastrophe exposures and thus did not gain market share in the global property cat re/insurance market.”

But the reinsurer does believe that, moving forwards on cat bonds, “We can expect investors to favour this segment.”

Swiss Re believes that capital efficiency is going to be key for the ILS market in future years, if the market wants to expand capacity to meet the surging demand for protection.

Summing up, the Swiss Re Institute said, “Overall, we see capital and capacity returning to the market in both traditional and certain alternative forms, but investment has been relatively opportunistic to take advantage of dislocations, rather than a broad-based surge.

“We expect these conditions to continue into 2024 given the remaining underwriting gap in most major economies.”