Expected fund returns could be down more than 50%

The latest data indicates that between 2014 and 2018 the ILS fund index would have returned 2.2% in a year experiencing an average level of natural catastrophe losses. The same level of annual loss would have generated a return of 5.9% between 2006 and 2013. The lower rate environment is likely to be an important cause of this change.

InsuranceLinked has combined the most recent data on losses, returns and pricing to try to understand how reinsurance pricing levels affect fund returns. The first chart shows the relationship between Munich Re's estimate of global insured natural catastrophe losses (in 2017 values) and Guy Carpenter's Global Property Catastrophe RoL Index. Large losses in 2005, 2008, 2011 and 2017 precipitated rate rises in the following years. But, despite the largest ever loss year in 2017, the rate level in the last four years remains well below the previous 13 years (something that is generally attributed to excess reinsurance capital).

The next chart shows the relationship between fund returns (as measured by the Eurekahedge ILS Advisors Index since its inception in 2006) and natural catastrophe losses. The funds have behaved as advertised - there is a strong correlation between the level of insurance losses and fund returns. However, for the same level of loss, returns have been lower in the most recent four years (orange spots) than in the first nine years of the index (grey spots).

On average, natural catastrophes have caused $56.7 billion of insurance claims each year since 2006. At this level of loss, the regression line indicates a return of 5.9% for the period 2006 to 2013 and 2.2% from 2014 to 2018. If you believe in medians, the numbers are 6.7% and 3.0% respectively.

The year that most outperforms the lines of best fit (2006) was the year after the high point in the GC RoL Index. The worst loss-adjusted returns were in 2018 - one year after the lowest level of the GC RoL Index. The timing and tenor of assets account for some lag in the response of returns to pricing.

These numbers may be optimistic. The reality is that both data and intuition suggest that global insured catastrophe losses are increasing much faster than inflation due to things like exposure growth, higher insurance penetration and climate change. This was illustrated by the blue dotted line in the first chart.

At the most recent renewal on January 1st, brokers saw little price change in the 'primary' reinsurance market and some positive rate change in the retrocession market. The largest increases may have come in the ILW market which experienced a shortage of capacity. Guy Carpenter's ILW desk commented:

The ILW market emerged as among the most dislocated of sectors at the January renewal. While the losses of 2018 were not significant for the ILW arena, some of the biggest ILS players in the space nonetheless withdrew expiring capacity. Supply was extremely short with only a handful of markets willing/abler to consistently offer terms. Any aggregate orders proved difficult to fill, and those that were bound showed a meaningful increase in pricing year-on-year. Occurrence protections also saw pricing hikes but to a lesser extent while peril and region-specific coverages were available largely ‘as before.’

The lateness of the renewal season and uncertainty around the supply side from the ILS community has led to a contracted ILW market at 1/1. This may ease as trapped collateral gets released and/or funds receive new mandates in the new year. The ILW market is not confined to specific renewal dates so a busy 1st quarter may lie ahead.

Note on 2018 data: In order to include the latest data, global insured losses use USD in 2018 terms (as stated by Munich Re) and the Eurekahedge fund returns are for the 11 months to the end of November. This will have a negligible effect on these charts.

Adam Alvarez

Posted: Monday, January 7th, 2019