Coronavirus sets stage for biggest ILS ‘test case’ since 2008 crash

Economic fallout from the coronavirus pandemic could cause short-term pain on the ILS market as investors pause inflows or dial back their allocations. But in the long term, the financial shock may provide another chance for the asset class to prove its case as a diversifier and safe haven and draw in more capital, investment consultants and fundraisers told Trading Risk this week.

If the financial crisis of 2008 was a successful trial run for how ILS would perform during a massive downturn in global equity markets, Covid-19 has set the stage for a second test. And while the resulting crisis this time around has not yet peaked, cat bond prices in the early phases have held stable. If overall performance holds, this could spur interest in the months and years to come.

However, the near-term impact could make for a more challenging mid-year renewal, as sources pointed out that some projected inflows and new mandates have been put on hold while investors assess the impact of global market turmoil on their portfolios.

"People are in a wait-and-see mode," one portfolio manager noted.

However, according to John Seo, managing director of Fermat Capital, some ILS inflows will start happening immediately.

“At the time Covid-19 struck, there was a significant pipeline of money processing. Any of that money that was advanced in the process by late February will come into our market,” he explained.

Plunging equity values will also mean some investors will want to rebalance and reinvest their equities portfolios – or dial back their ILS allocation if this has overshot its target.

As observed during the 2008-2009 financial crisis, this may lead some ILS holders to start redeeming securities in order to raise cash.

“If people need liquidity, they may sell off ILS precisely because it’s a strong performer, so we could see some outflows,” one European industry source said. “If the stock market is down 30 percent, you may have to let 2-3 percent of ILS go, too, to keep the portfolio in proportion.”

However, the ILS market composition has changed since the 2008 crisis in a way that may insulate it from this kind of reaction – with fewer hedge funds and multi-strategy managers as ILS specialists with buy-and-hold strategies have come to dominate the market, alongside larger growth outside the cat bond market.

Aon estimated hedge funds held 7 percent market share in cat bonds in 2008, with specialist ILS funds on just 36 percent share – which spiralled to 59 percent in 2019, with hedge funds falling to 5 percent (see pie charts). This could help to minimise the level of withdrawals compared to 2008, when some under-pressure hedge funds turned to the cat bond market for cash.

When investors come to weigh up the alternatives ahead of them as they are rebalancing their portfolios, there are some factors that could draw them to ILS but others that may make it relatively less attractive, said Siglo advisor Michael Knecht.

On the positive side, ILS still offers a hedge against interest rate risk, but its relative attractiveness is lower than high-yield alternatives right now. “These two camps will balance each other out," he predicted.

In Seo’s view, the mindset of investors will play a role as well.

“Paralysis is a possibility for some institutions,” he said. “ILS allocations are still relatively small at top portfolio level, and ILS allocations are generally at the bottom end of target ranges. So the numbers at top portfolio level are not as important as the psychology of the allocating institutions.”

Longer-term gain

Despite the potential short-term pain, if inflows and outflows in the ILS market follow the same trend they did a decade ago during the financial crash, the limited ILS sell-offs that occur early in the cycle may later be recouped, leading ultimately to market growth.

“In 2008 and 2009, when the ILS market was still in its infancy, there was some short-term reduction in ILS allocation – some reshuffling and rebalancing – but once the market stabilised, we saw a substantial increase,” one portfolio manager explained.

“This could be a new test case and ultimately make the entire market much stronger,” he added.

Some may even experiment with incorporating as much as 10 percent ILS allocation in their portfolios, though such a configuration would be unexpected, according to Mark Wilgar, investment advisor at Cambridge Associates.

Looking ahead, market participants agree that cat bonds would be a bellwether for any potential ILS sell-offs.

“If there is any sell off, you’ll see it in the cat bond market,” one ILS consultant noted, adding that spreads had held largely stable in February.

As reported in Trading Risk this week, cat bond prices remained almost flat in recent days despite seasonal effects and the worsening effects of the Covid-19 pandemic on stock markets.

For now, it is impossible to estimate how profoundly the coronavirus will affect society or the markets, but the ILS sector has adopted an attitude of cautious optimism.

“ILS has performed as expected owing to its uncorrelated nature and market participants may be looking more at it,” one industry participant pointed out.

"Our investors are extremely happy to have an asset class which is uncorrelated in these times,” Kai Morgenstern, co-founder of Tangency Capital said. “The current situation underlines the asset class’ value.”

Wilgar added that so long as ILS returns hold up and the market avoids major hurricanes or earthquakes, he would expect more client interest.

“I’m struggling to find anything else that’s been as resilient as ILS to market volatility at the moment,” Wilgar said.

“On a pure returns basis, ILS has not kept up with many other assets classes since 2017, but later if people look at how it held up in 2020 when the world imploded, that’s the story ILS needs to attract wave of new capital,” he added.

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