AM Best: Casualty ILS needs discipline

Rating agency AM Best states that as the casualty insurance-linked securities (ILS) market grows, participants must ensure underwriting discipline and risk transparency develop together to keep pace with investor demand. Some reinsurers have raised concerns about the speed and framework of specific casualty ILS initiatives, even as capital market innovation offers significant capacity.

AM Best notes that casualty ILS remains a relatively small part of the overall alternative capital market. This limited penetration is notable given that industry observers have discussed the possibility for over a decade. While ILS transformed parts of the property catastrophe market, the characteristics that made catastrophe risks attractive have proven far more difficult to replicate in casualty business.

Those attractive characteristics include low correlation to capital market returns, shorter investment duration, event-driven loss emergence, and relatively transparent modeling assumptions.

Market Size and Historical Limitations

Investor interest in casualty-linked structures continues to grow. However, AM Best emphasises the market remains substantially smaller than many earlier projections envisioned. Whether recent innovations can overcome historical limitations is one of the more closely watched developments within the broader convergence market.

The agency indicates reinsurer concerns are primarily two-fold. They focus on the concept itself and whether all participants have a comprehensive understanding of the risks being transferred.

Key Risks and Investor Concerns

Casualty liabilities can take years to emerge. They are influenced by evolving legal and social environments, as well as capital market volatility. This leads to significant uncertainty regarding eventual loss development and the returns on the float that seem appealing to investors.

In contrast to many catastrophe exposures, the underwriting risks linked to casualty business may not become fully evident for prolonged periods. Numerous traditional reinsurers contend this uncertainty is inconsistent with the overarching premise of ILS.

AM Best also flagged how a number of industry participants have showcased the potential for elevated investment risk within certain proposed structures. There are concerns investors may predominantly concentrate on attractive yield opportunities without fully understanding the complexities of the underlying liabilities. The significant effect that the timing of those liability payments can have on overall returns is also a factor.

The agency acknowledges this has been evident in recent years within the private credit markets. Early redemptions have reportedly caused devaluations in times of liquidity needs.

Not a Universal Issue

AM Best states these concerns do not apply universally to the entire casualty ILS market. Many casualty ILS structures are being developed thoughtfully and involve sophisticated participants with substantial expertise utilizing conservative investment allocations. However, the industry’s experience demonstrates that isolated examples of poorly structured transactions can sometimes influence perceptions of an entire asset class.

As casualty ILS continues to evolve, market participants will likely remain focused on ensuring that underwriting discipline and risk transparency develop concurrently with investor demand.