Distressed opportunities will leach inflows away from ILS in near term

Attention has focussed on how much ILS capital could flow out of the market due to Covid-19 redemptions, but the impact on new allocations is expected to be just as severe in the near term – with an overall greater impact anticipated in some pockets of capacity than others.

There has been much speculation over significant major outflows occurring at mainstream ILS managers as investors seek to free up cash, but so far these fears are overblown.

However, there is no doubt that some cash will be taken off the table, beyond initial reports of multi-strategy investors seeking to cash up cat bonds, as indirect investors backing ILS specialists seek to trim back their ILS holdings, even if they are not moving out of the asset class.

Across the board, a further roughly 10 percent drop in ILS capacity is a reasonable, possibly conservative estimate which, coming on top of retractions at the start of the year, is going to be one of the pressures that some expect to force property reinsurance rates closer to a hard market.

As previously noted, the shift towards a pension fund investor base over the past decade is expected to insulate the market against greater reaction, as these funds face less pressure to realise cash. In addition, given the size of the asset allocations of these organisations and stable ILS performance, the sector is clearly far from the top of investors' minds right now.

Many projected that funds with more reliance on retail and hedge fund capital will be harder hit as these segments are typically more reactive. This could hit the already contracting sidecar market if support shrinks further from major participants with funding from high-net-worth retail capital, such as Stone Ridge, Amundi Pioneer or other multi-strategy firms. The retro market is also a likely candidate for further tightening as hedge funds chase other opportunities.

Mainstream ILS funds will also experience some impact from rebalancing as investors look to scale back overweight holdings and re-invest elsewhere.

Meanwhile, tighter ILS capacity will be matched by a hit to rated reinsurance balance sheets because of investment markdowns. However, given the industry's overall health and historically low levels of underwriting leverage, ratings agency have said they generally remain safely within range of target solvency levels.

Moody's for example projected that European (re)insurer solvency ratios would have fallen to 190-200 percent by 31 March, from 210 percent at year end, and noted ratios were held up from falling another 5-10 points by widespread suspensions of dividend payments.

Inflows set to dry up in short term

On the ILS front, just as critical as outflows to overall capacity levels will be the impact on new inflows.

Any new investors to the sector will now be held up from completing due diligence processes in person and, given the higher hurdle to get new investors on board at such extreme times, market participants generally believed that inflows would have to come from existing investors.

Even then, managers emphasise the many competing demands for investors' attention right now – as they look to rebalance and reinvest, their priorities are likely to be taking advantage of distressed pricing in other asset classes.

This could have a particular impact on the higher-risk-return segments of the ILS market such as retrocession, where 20+ percent returns might be achievable in a light cat year, but carry the possibility of a significant loss.

Even these returns will be outstripped by 20-40 percent return targets from opportunistic, more mainstream credit ventures in marked-down segments, for those who are ready to re-risk. And these investors are more likely to include the opportunistic hedge funds that make up a greater market share in retro business than other ILS segments.

But the distraction factor will also apply more widely to institutional investors, as one consultant said short-term opportunities will rocket up their priority list – emphasising that although firms might not change their long-term ILS strategy or commitment to the asset class, short-term tactics could lead them to focus elsewhere for now.

Moving beyond the short-term disruption, the Covid-19 crisis could still be a major selling point for the ILS industry as the disaster has highlighted its non-correlated resilience.

"There's a huge growth opportunity in around 18 months," one fund manager noted.

However, for now the diversifying message may have to wait to gain more attention.

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