ILS Market: A Deep Dive into the Harvey and Irma Waters

Yesterday, Locke Lord touched on the general implications of the recent devastation caused by Hurricanes Harvey and Irma on the Insurance-Linked Securities (“ILS”) market here.  With Irma having now left the Florida keys (and reportedly having destroyed upwards of 25% of all homes in the area), it is now possible to step back and more fully assess what those damages mean to the ILS market and its capital market investors (including pension funds, endowments, hedge funds and family offices), both now and into the future.

Early analyses suggest that the insurance industry will be substantially impacted by Hurricanes Harvey and Irma, with an estimated total industry loss of $40 billion caused by Harvey and an additional $20-40 billion resulting from Irma’s coastal clash. However, indicators suggest that the ILS market as a whole will endure.  With favorable reinsurance terms readily available to insurers over the recent years, primary insurers are positioned to be relatively protected from the recent hurricane exposure, shifting much of the loss to traditional reinsurance as well as the ILS markets.   Nevertheless, most analysts have been nonplussed with the potential for impact on the ILS market.  A.M. Best, for example, is forecasting an earnings downturn but not a “capital event” that would result in a drastic market shift.  Furthermore, as ILS markets are driven predominantly by investor reactions and concerns, it is likely that ILS funds will expedite their claims settlement processes in order to avoid litigation and relieve investor uncertainty.  Put simply, calm markets are less volatile.

Ultimately, while we certainly do not wish to downplay the personal loss, devastation and havoc inflicted by Harvey and Irma, both market and climate conditions indicate that the ILS market has been spared its worst case scenario. For starters, Gary Martrucci, a director at Standard & Poors notes that CAT bonds are traditionally well oversubscribed, such that even if some investors retreat from the industry, there are still ample funds flowing into the ILS market.  Second, many loss forecasts appear to fortunately have been overstated.  Had Miami been hit directly or had Irma not veered to the west, losses to the insurance industry could easily have doubled in comparison to current loss projections, thus putting significant stress on the ILS market.   As it stands today, current loss estimates may not impact many ILS facilities at all.  As a result, S&P does not foresee any of its rated CAT bonds suffering a reduction in principal.  Accordingly, capital market investors in CAT bonds will likely avoid significant losses.

If Katrina may serve as a lesson of predictive market analysis, the ILS market is likely to continue growing and expanding to satiate investor demand.   After Hurricane Katrina, attention drifted to CAT bonds and other ILS alternative reinsurance investments (including side cars, collateralized reinsurance, derivatives and ILWs) as alternate means of hedging risk and participating in the insurance industry.  Further, the aftermath of Katrina saw market recalibrations in the form of price and interest-rate hikes, which we expect to see to some degree in connection with recent events.  And, while it is possible that we will also see some short-term local retreats (much like Hannover Re’s efforts to limit its Florida exposure after Hurricane Katrina), any price increases will “likely be limited”, according to Steve Hearn, CEO of Ed Broking Group Ltd.

Ultimately, the ILS market has grown into the formidable investment avenue it is today because of what it offers to investors: an ability to hedge and to outperform competing markets. For example, Aon Benfield’s U.S. hurricane bond index provided an 8.7% return on average over the last decade, compared with the 6.9% average for high-yield bonds over the same time period.  In addition, the ILS Market also help investors hedge against their exposure to traditional markets, which usually are not correlated with ILS returns.  As such, we expect to see the ILS market continue to grow, evolve and develop in the wake of Harvey and Irma.  What we do not expect to see is any substantial disappearance of ILS players; the ILS market has grown substantially since Katrina’s devastation 12 years ago into a robust alternative to traditional reinsurance markets, and despite some losses to ILS investment tranches resulting from Irma and Harvey’s impact, ILS and the capital it attracts from other markets plainly is here to stay.