UK’s 2022 financial turmoil and double-digit returns fuelling ILS cat bond shift: Albertini

2023 is poised to be a record year for cat bond issuance and a key factor is the UK’s brief financial crisis last year, which reminded pension fund managers around the globe of the importance of liquidity, according to Leadenhall Capital Partners CEO Luca Albertini.

Speaking at The Insurer’s Pre-Monte Carlo Forum, Albertini said: “Brokers have indicated that in the first half of this year, there were as many cat bond issuances as last year, showing that investor demand has been very healthy.”

But he contrasted this with collateralised reinsurance placements, where pension funds – the largest component of the ~$100bn ILS market – remain cautious on issues such as trapped capital and limited liquidity.

Albertini also referenced the strong “double-digit” returns that are currently available to cat bond investors. At H1 2023, the Swiss Re cat bond index – which measures total returns on outstanding cat bonds – was up 10.3 percent. Indeed, after a strong July-August, it is looking increasingly likely that the authoritative index’s record annual return of 15 percent in 2007 may be exceeded this year.

In addition to strong returns, however, pension funds are particularly concerned about liquidity after UK life insurers in September and October 2022 were confronted with margin calls after leveraging their gilt portfolios with liability-driven investments. It sparked a mini confidence crisis until the Bank of England stepped in to stabilise the markets, a key factor in the exit of British Prime Minister Liz Truss.

While sidecars, industry loss warranties and collateralised XoL reinsurance placements are locked in, the secondary market for cat bonds provides investors with the additional reassurance of liquidity in the event an early exit is required, Albertini explained.

“Clearly, there has been a shift to liquid strategies,” he said.

“Yes, you still have the risk of collateral trapping but you can trade out within two weeks [with cat bonds].”

On the issue of trapped collateral, Albertini estimates that around $20bn – or “20 percent give or take” – of the $100bn ILS market is currently locked. This means it will either be returned to investors or drawn down to cover incurred losses, but in the meantime cannot be deployed as live risk capital.

Speaking to an audience of nearly 300 London executives, he said ILS fund managers like Leadenhall Capital remain concerned about excessive trapping of capital.

“Of course, collateral trapping is a prudent way to manage the development of reserves, especially when there is uncertainty, but it is very hard to find clarity and to properly codify,” he noted. Albertini added that he is at times sceptical when loss estimate reserves are frequently set close to positions that enable a broker to lock higher layer positions.

He reminded the audience that it’s a hard market with capacity less freely available and fund managers may simply decide not to renew if the behaviour is “abusive”.

“So some of the behaviour when it's abusive will be punished by having less capital available. It is part of being ethical and being and being sensible in developing relationships.

“I'm Italian, I remember and I keep a grudge,” he joked to the audience.

ESG

The Leadenhall Capital founding partner concluded with warnings that capital management firms will increasingly consider the ESG credentials of reinsurance companies in the face of mounting regulatory obligations.

“On ESG, we’ve heard a lot about net-zero initiatives in the reinsurance space. For us, this is becoming very topical,” he said.

“This is currently being embedded in European litigation, firms will have to declare where they stand. It’s increasingly risky from an investment management standpoint to say you don’t consider ESG – but if you do declare and then don’t follow through, you may be fined for greenwashing.”

For Leadenhall Capital, Albertini said this means that at issuance, all positions will be rated on a three-tier traffic light system using both qualitative and quantitative aspects, including ESG factors.

As climate change remains a significant reservation for investors in terms of forward-looking modelling horizons, the firm will also carry out an assessment of a reinsurer’s environmental credentials, including plans on how to navigate the reinsurance book through the net-zero transition, as well as the investment book.

And on governance, while holding different meanings depending on the company, for reinsurers this is generally translated in underwriting performance and reserving policy.

“For me, it’s about transparency in reserving, how robust is your underwriting, and the pipeline in delivering value for shareholders and securing capital,” Albertini concluded.