Aon’s Schultz: Modelling inaccuracies “principal concern” for ILS market

The industry’s inability to accurately calibrate models is the “principal concern” for ILS investors, with 2022’s loss experience exacerbating this issue and causing a number of deals to be delayed during the fourth quarter, according to Aon Securities CEO Paul Schultz.

Speaking to The Insurer TV following the launch of the broker’s Q4 2022 ILS Quarterly Report, Schultz said climate change and the increasing volatility of weather events have caused risks to proliferate, impacting the risk-return profile of ILS.

Together with the challenging investment environment with respect to inflation, higher interest rates and considerable movements in foreign currencies, the fourth quarter proved a “challenging” one in terms of getting ILS transactions over the line.

Schultz explained that following Hurricane Ian, ILS investors paused to understand their exposures to – and valuations of – their portfolios, resulting in a number of deals being delayed.

According to the report, Hurricane Ian’s current principal loss estimate is $38.2mn for cat bond investors, representing 0.11 percent of the overall outstanding cat bond market.

“All of this together created a pretty challenging final quarter,” Schultz told The Insurer TV’s Close Quarter programme.

“But as we are now past it and can reflect, this industry has really prided itself on getting through challenging times which adds to the resiliency of the asset class and to the sustainability and durability of ILS going forward,” he said.

The dislocation created by Ian meant “putting capital back to work” in Q4 was another challenge the ILS market faced.

As of 30 December, Aon Securities’ pricing valuations show a mark-to-market reduction in total cat bond market value of 7.44 percent since the week prior to Ian, according to the report.

Q4 focus on indemnity-based transactions – a new trend?

Aon’s report highlighted that indemnity-based transactions had been supported at tighter margins than index-based transactions, with the margins sitting at 6.67 percent and 10.30 percent respectively.

Asked whether or not he saw this as a new trend in the market, Schultz said time will tell, but suspected the increased uptake in indemnity-based transactions was a reflection of investors’ attempts to “attract the maximum number of issuers to the marketplace”, rather than any concrete preference.

“Whether it's a point of time observation, or whether it's a trend, I guess we'll find out as we progress a little bit further in 2023,” he said.

“I think fundamentally, when you just step back from a portfolio construction perspective, it makes sense to continue to be able to deliver investors and help issuers do both types of transactions.

“From an investor's perspective, you can diversify some of the systemic risks that you have if you go down this single trigger for all the same type of transactions.

“And so, from a portfolio construction perspective, it makes sense, attracting the maximum amount of issuers to the marketplace, and whether that's through indemnity transactions or index deals or parametric deals or wherever that may take us in that journey, I think that just leads to sort of a broader market participation generally and more growth opportunities,” he explained.

However, he implied the market’s adjusted strategy actually reflected fears of major cat bond losses from Ian.

Now that exposure in the cat bond market is largely “mark-to-market”, Schultz expects that “a diversity of transactions will continue to be the norm going forward”.

Yet, with concerns over modelling still prominent, it is difficult to have confidence that the market’s return to the “norm” will not be hindered by unmodelled and unforeseen exposure.

Fresh capital mandate

However, Schultz feels investors have “received a new mandate to bring fresh capital into the market, which he expects will create “a more orderly transition from Q4 and into 2023”.

This was reflected in a December acceleration in trade volume, with 71 trades compared to only 55 and 47 in October and November, as identified in the report.

“With this fresh capital we are seeing existing investors allocate more,” he said, joined by “new interest from different types of investors that are looking to deploy capital”.

“The new ILS investors are mainly opportunistic hedge fund and multi strat investors, who are unlikely to provide longevity in the market, but have provided much needed capital in a time when capital was under duress,” said Schultz.

Trapped collateral remains a challenge for some parts of the ILS market, but Schultz believes it is not “too large” an issue for cat bonds.

This assessment was based on the bond market’s relative position compared to industry loss warranties, collateralised reinsurance and collateralised retro, which he said “lended themselves towards trapping”.

Looking forward, Schultz expects to see a “very disciplined approach” from ILS managers and from investors with regards to deploying their capital.

“No one wants to deploy capital, have so much supply that you create a change in that supply-demand balance. And I don't think anyone wants to create a change in that supply-demand balance, so you will see much more discipline in 2023,” he said.

“But, at the same time, we've come a long way. If that 40 to 60 percent is an indication of where rates have moved, that's a lot of rate movement in a 12-month period of time.

“I think now is the time to start to get back to business, which is: ‘Let's get the transactions done at those elevated levels, let's create a little bit more order, create a little bit more predictability for those that want to issue into the marketplace, and make sure we create the return opportunities for the investors’,” he concluded.

In the second part of The Insurer TV’s interview with Aon Securities CEO Paul Schultz which will be publihsed next week, we delve further into the ILS market opportunities to be seized in 2023, predict the size of the cat bond market and new areas ILS investors are keen to explore.