Rate increases no longer a panacea for ILS fund results: AM Best

Rate increases alone are no longer considered sufficient to improve the underwriting results of insurance-linked securities managers and reinsurance firms, according to AM Best, who believes that after consecutive years of heavy catastrophe losses the only answer is continued improvement of the quality of portfolios of risk.

For some years now, we’re been explaining in our coverage of the insurance-linked securities (ILS) fund market that rate increases are not the only way to improve the returns of portfolios of reinsurance and retrocession.

Terms and conditions, structural enhancements, attachment points, retentions, are all factors that ILS fund managers have been working to enhance, now through multiple renewal cycles.

Back in 2019 we explained that, after the major losses of recent years, terms and conditions associated with reinsurance, retrocession and insurance-linked securities (ILS) renewals, as well as the way you access the risk, were rising in importance for ILS fund managers.

These factors were seen as just as important as rates and the majority of ILS managers have been working hard to improve them through each renewal cycle over the last few years.

Around the June 2020 renewals we wrote that ILS fund managers were shifting their portfolios towards more remote layers of risk in the hardening market environment, while the focus on terms continued as well.

Then later that year, we discussed the fact ILS fund managers were constructing portfolios that can deliver much improved insurance-linked securities (ILS) returns, thanks to the enhancements that were being made in the face of market dislocation.

Finally, after the 2021 renewals we explained that ILS funds continued the renegotiation and fine tuning of terms and conditions, with named perils, attachments and buffer loss clauses particularly in focus.

So, it’s been clear for a while that rate rises alone are not the answer and that ILS fund managers need to work on the quality of their portfolios, while maintaining the usefulness of their coverage for clients at the same time.

AM Best has published a new report on this phenomenon today, saying that, “The substantial losses in recent years have made clear that rising rates are not enough to improve underwriting results for ILS managers and reinsurers.”

Because of this, AM Best says that, “The ILS and reinsurance industries have focused negotiations on terms and conditions, restructuring coverage features such as adding per-event caps in aggregate covers and raising attachments and deductibles.”

“ILS fund managers are re-underwriting and de-risking their portfolios, as rate increases are no longer a panacea for improving underwriting results and satisfying skittish investors,” explained Emmanuel Modu, managing director, Insurance-Linked Securities, AM Best.

“Despite the losses, the ILS market remains attractive to investors due to its low correlation with the broader capital markets, providing a valuable source of diversification,” added Wai Tang, senior director, Insurance-Linked Securities, AM Best. “However, investors are understandably fatigued by the poor performance of some ILS sectors.”

As reinsurance firms have shifted away from some lower layers of risk, so too have ILS funds and the result has been a de-risking throughout the industry value chain, as primary insurers have also become more selective of their policies, to avoid any significant risk concentrations, AM Best explained.

This has also opened up some opportunities for those with strategies that can target lower-layer risks, and AM Best explained that, “This mismatch in the supply and demand of capital has led to protection sellers receiving preferential treatment from reinsurance brokers if they are willing to provide coverage for lower-attaching layers.”

But in the main, ILS managers are taking advantage of improved market pricing and conditions, with a focus on sound re-underwriting and de-risking so as to “rebuild ILS portfolios, with the potential to deliver their target returns but with lower volatility,” AM Best continued to explain in its report.

The shift in appetite for aggregate coverage has also been well-covered over the last twelve months of so, and this continues to be a factor that will affect future renewals.

The catastrophe bond market has benefited from this, as well-structured, named peril aggregate protection remains available in cat bond form, both on a reinsurance and retrocession basis (as evidenced with Swiss Re’s newest cat bond here).

The fact rate increases alone are no longer the answer to dwindling ILS fund returns is well-understood and it has ramifications for end-investors as well, as timing entry into the market just because rates have hardened is no longer a guarantee of the best performance, as it really does depend on the portfolio allocated to and the way the ILS manager has constructed and managed it over the last few years.

Which is why we see divergence in returns continuing to be a trend, as loss events affect different ILS fund strategies to a differing degree, with those that have taken the strongest line on T&C’s and re-underwriting likely to be the best positioned in many scenarios.