The ILS market is in a bit of a pickle as it heads into the New Year.
After two nerve-jangling years of persistent losses and massive deteriorations which caught some investors flat-footed, the alternative capital market is re-examining its fundamentals.
The former wunderkind of (re)insurance has stepped into the harsh reality of adolescence.
You would think that chastening experience alone would serve to push the market towards making sure this kind of thing happens less often – and that investors are aware of the risks they are taking with instruments such as cat bonds.
At the end of the day, nascent markets as technically complex as ILS almost require a reckoning at this point in their development.
Some people have to get burned before the market as a whole can improve. This is financial evolution theory 101.
Given the current environment, it is notable then that the head of one of the original guardians of the ILS market, Christian Mumenthaler of Swiss Re, has warned that the market faces structural stains on a scale of the US mortgage industry circa 2008.
In an interview with the Financial Times, Mumenthaler highlighted the knowledge gap between those structuring these instruments and those investing, with people taking risks they don’t understand just to be in the game.
Maybe there is a point to be made here with retail investor exposure to the sector. ILS is certainly a niche, technically challenging market for any investor, and the spectre of angry retail buyers crying foul is a legitimate worry to have.
Since the crisis, companies have (rightly) become more conscious of the downside risk on their books from complex, financially engineered investments. ILS fits that bill nicely.
That said, I remain sceptical that there is a looming financial crisis linked to enormous retail investor losses in the ILS market.
Mumenthaler’s comparison has technical credibility to an extent. After all, ILS is a complex, artificially constructed securities market which has attracted institutional capital for its diversification benefits.
However, for starters, it has nowhere near the systemic importance of US mortgage capital.
ILS is a (mostly) uncorrelated sector. Heavy insurance losses are not going to result in people being unceremoniously booted out of their homes because of financial losses – at least directly.
Perhaps Mumenthaler’s arguments have a whiff of the market traditionalist finally proven right in their staying of the course. It is easy to sneer at new things when they face their first hurdles, and when it is in your direct economic interest to talk them down.
Just look at how many people have taken the opportunity to bash cryptocurrencies because prices fell to thousands of dollars higher than they were even two years ago.
Financial innovation can get messy at times. That is where the ILS market is right now, facing up to its first serious challenge against its right to exist.
Existential challenges are motivating, not depressing. There is still a lot to come from the ILS sector. Just don’t tell the haters.