ILS spreads may tighten further, but K2 raises conviction on ILW’s

Analysing the insurance-linked securities (ILS) market outlook for the third-quarter of 2023, K2 Advisors, the hedge fund focused investment management unit of Franklin Templeton, believes spreads could tighten further, especially in catastrophe bonds, but it remains constructive on ILS and has now signalled an overweight view on industry-loss warranties (ILW’s).

K2 Advisors has had an overweight or strongly overweight view on catastrophe bonds, private ILS transactions and retrocession since the start of this year.

Now, the asset manager has raised its conviction on investments into the industry-loss warranty (ILW) as well, shifting from a neutral stance to one where it recommends being overweight ILW’s.

Catastrophe bonds, private ILS (so collateralized reinsurance arrangements) and retrocession remain the three sub-strategies in the alternative hedge fund world that K2 Advisors has the highest conviction for currently.

Now, ILW’s have climbed up to become the sub-strategy sitting in seventh of a list of a wide-range of hedge fund alternative asset classes.

Summarising the outlook for Q3 2023 for insurance-linked securities (ILS) investments, K2 Advisors said, “While spreads have tightened from all-time highs in late 2022, the forward-looking outlook remains attractive to us.

“Total yields remain elevated following the June 2023 renewals which saw continued tighter reinsurance capital and higher money market rates.”

The asset manager acknowledges that there has been “a large inflow of cash into the sector, which has dampened the level of rate increases,” but noted that the “June and July renewals saw strong rate increases as expected.”

“Despite that inflow, we believe the broader ILS market remains materially attractive in terms of both spread and total yield,” K2 Advisors said.

Catastrophe bond market yields are still at “historically attractive levels” and K2 Advisors believes this is still “an attractive entry point for the asset class.”

The firm notes that the cat bond market spread has “consistently tightened over the last eight months” but notes that still, the market’s spread remains at a level not seen since the aftermath of hurricane Sandy in 2012.

“While we would not be surprised to see the spread tighten more throughout the year, absent any significant natural catastrophe activity, we believe forward looking prices and spreads will stabilize at higher levels than prior to Hurricane Ian,” K2 Advisors explained.

A supply-demand imbalance persists in reinsurance, especially for riskier layers and strategies, and placing those into the ILS market remains challenging, the asset manager said, which is driving greater retention of losses for primary carriers and cedents.

At the same time though, there has been some unlocking of trapped capital which has helped to boost capacity in the ILS market as well, as we’ve reported recently here.

Overall, K2 Advisors remains very constructive on ILS as a whole, especially cat bonds, private ILS and retro, but now with ILW’s also becoming more attractive in the manager’s view as well, which we’d imagine is driven by the continued gaps in capital supply that might make ILW’s an attractive segment to invest in towards year-end.

Also read our last article citing K2 Advisors, where we discussed the firm’s statement that portfolios of reinsurance and retrocessional risk transferred to the capital markets, through catastrophe bonds and other insurance-linked securities (ILS), in 2023 are potentially the cleanest ever seen.