Why cat bonds, ILS are depressing reinsurance rates

Despite last year’s devastating hurricanes, investors are happy to keep shovelling money into cat bonds and insurance-linked securities (ILS), which in turn are making reinsurers think twice about hiking rates.

The catastrophe bond and ILS markets have “grown hugely over the last 12 months,” Phil Cook, CEO of Omega Insurance Holdings Inc., said Tuesday during a speech at The Insurance Institute of Canada’s annual Industry Trends breakfast, held in Toronto.

In its annual ILS report released in September 2017, Aon Securities reported there was US$25.8-billion worth of catastrophe bonds on risk (both property and life) as of June 30, 2017. This was up by $3.3 billion from June 30, 2016.

Investors lost money on several catastrophe bonds due to the 2017 hurricane season, but those cat bonds “immediately got replacement capital from the same investors,” Cook observed.

He said investors were willing to put more of their money into ILS partly because they “rely on the law of averages,” meaning they are confident that catastrophe losses are normally not as high as they were in 2017.

During 2017 Q3, the insurance industry was hit with losses, possibly in excess of US$100 billion, from the Sept. 19 earthquake that struck Mexico, as well as three North Atlantic hurricanes (Harvey, Irma and Maria) that caused heavy U.S. property losses in August and September.

It is “very tough” for traditional reinsurers to compete with insurance-linked securities that “have almost a total loss and could raise the capital in an instant immediately after,” Cook said Tuesday.

In a report released Nov. 15., A.M. Best suggested about US$25 billion in 2017 Q3 catastrophe losses could be covered by alternative capital.

Investors also like cat bonds and ILS because of their attractive return on investment.

Artemis.bm reported this past November that some ILS instruments provide returns of 6% to 8% a year. By comparison, the yield on U.S. three-year treasury bonds was 2.12% Tuesday while the average yield on Canadian government 3- to 5-year bonds was less than 2%.

As for the reinsurance industry, its return on equity (on an annualized basis) dropped from 12.4% in 2012 to 8.1% during the first half of 2017, A.M. Best Company Inc. said this past September.

A.M. Best said on Jan. 5 that it is “maintaining a negative outlook” on the property and casualty reinsurance sector due in part to “pronounced pressure” on United States catastrophe rates. This pressure, A.M. Best added, is coming from competition from ILS.

While primary insurers “are quite happy to have fairly depressed reinsurance costs,” Cook said, “we need reinsurers to be there.” He added reinsurers “can only be there if they are making a reasonable return on their investment.”