K2 sees cat bonds as stand-out for growth. Price discipline drives spreads

Increased investor price discipline across insurance-linked securities (ILS) and reinsurance linked investments is helping to drive returns higher, but catastrophe bonds are the stand-out as the ILS market segment likely to grow in 2022, according to K2 Advisors.

The investment research team of K2 Advisors, the hedge fund focused asset manager unit of investment firm Franklin Templeton, has been recommending clients allocate to certain areas of the private ILS market and catastrophe bonds for some quarters now, suggesting improving fundamentals.

The recommendations remain, at “strongly overweight”, for both catastrophe bonds and private ILS, but K2 Advisors is underweight industry-loss warranties, feeling that segment less attractive right now and neutral on investments into retrocessional reinsurance.

Rates in ILS have “hardened throughout the risk tower” K2 Advisors analysts explained, with investor sentiment towards certain higher-risk ILS categories waning and leading to a supply / demand imbalance in the space.

In catastrophe bonds, spreads have continued to widen out with hurricane season approaching, a trend many expect could continue a few weeks more.

It’s expected there will continue to be a lack of capacity until the mid-year renewals are completed, with reinsurance and retrocession rates hardening as a result.

No significant influx of new ILS capital is expected, the K2 Advisors team explained, and some longer-term ILS investors continue to view the segment as one on pause, while they evaluate how the market is adapting after its challenging loss years of late.

“It appears that all ILS market segments, except for catastrophe bonds, will not experience significant growth in 2022,” the K2 Advisors outlook explains.

Adding, “There has been increased investor price discipline, which when combined with lower levels of investor demand, has led to widening spreads throughout the market.”

With catastrophe bond issuance now standing at $7.6 billion year-to-date and the outstanding cat bond market standing some $1.3 billion higher than at the end of 2021, growth is already evident in cat bonds.

In addition, the assets under management (AuM) of the major UCITS catastrophe bond fund strategies had increased through Q1 2022, a trend we expect will continue once the end of current quarter figures are in.

We are beginning to see what could be a slowing in the cat bond market’s spread widening, with a number of recent issues pricing within their initial guidance. However, it is still a little early to be calling an end to the market widening and we’ll need a little more evidence to emerge before that can be called.