After a chaotic week with stock prices see-sawing, a US government bond sell-off, then a partial US policy reversal on tariffs, how will it all impact on the ILS industry?
On the face of it, the pause on US import tariffs announced last Wednesday was a reprieve for ILS managers, after it led to some recovery in stock prices.
The denominator effect is an immediate concern for ILS when stock prices fall sharply, as investors can look to rebalance their portfolios by selling down liquid positions like cat bonds. Or more generally, investors can become less willing to allocate to ILS if it looks overweight next to other asset targets.
Several managers indicated that investors had been in touch, “in case they wish to pull out”, as one put it.
But sources indicated there were no signs of this translating into rebalancing decisions being made or selling pressure arising as yet.
Another said equity prices would need to fall by a further 10% from their lowest point last week for rebalancing to significantly impact ILS.
The denominator effect has impacted ILS funds several times in recent memory, including during the credit crunch of 2008-09, the pandemic panic of 2020 and again during the UK’s liability-driven investment crisis of September 2022.
One manager noted that while rebalancing is always a potential problem for ILS, the gradual migration of capital from private ILS to cat bonds over the past couple of years has made it easier to manage if it does happen.
Cat bonds stood for ~$50bn of total ILS capital of ~$115bn (43%) as of year-end 2024, up from ~$40bn of a total ~$108bn (37%) two years earlier, according to Aon.
High uncertainty and the ‘distraction factor’
Still, the pivot to greater trade protectionism by the US could have significant fallout for ILS in other ways.
The big concerns are around investor confidence when it comes to awarding mandates and the impacts on loss costs from expected higher US inflation rates.
With the US administration signalling a 90-day period of negotiation with approximately 74 trading partners globally, there remains a high amount of uncertainty about what the eventual size of tariffs will be and what goods they will apply to.
China is levying a 125% import tariff on US goods, in retaliation for a 145% tax being applied the other way.
Over the weekend, the US removed tariffs on technology products like smartphones, laptops, semiconductors and solar panels in what is being billed as a temporary reprieve.
Managers cited the “distraction factor” of market turmoil and the changing landscape as among the key challenges, with one noting mandate discussions could get parked while investors sort out other issues in their portfolio.
It is hard to imagine investors having confidence to allocate significant sums, until at least the end of the negotiation period in mid-July, potentially impacting the availability of ILS capacity for mid-year deals.
Offsetting these challenges, the non-correlation pitch will also come into play, as it remains a major point in favour of ILS, particularly at times of market stress.
A source noted: “When it comes to natural catastrophes, Trump and his tariffs have zero influence on what Mother Nature will do in the future.”
While constricted inflows are not ideal, the silver lining could be that prevailing downward pricing trends in ILS are halted or reversed.
If it does play out this way, it would help to maintain the competitiveness of ILS against other investments like high-yield corporate debt, at a time when investors are actively weighing their options and high-yield spreads have closed some of the gap to cat bonds.
The crisis has also sparked debate on whether there should be less focus on US treasuries as a reserve currency, with the possibility that this question could be raised over ILS structures in future.
Almost all collateral backing ILS contracts is invested in US Treasuries, with the US dollar the currency of issuance for most deals.
The main exception is where collateral is invested in International Bank for Reconstruction and Development notes. IBRD notes are used as collateral in several government-sponsored deals like Mexico’s $175mn parametric, Pacific named storm bond and Jamaica’s $150mn parametric named storm note.
Last year, Tokio Marine became the first sponsor to issue a bond using SOFR puttable notes as collateral, with its Kizuna Re III quake bond.
Inflation impacts on loss costs
Aside from financial market tumult, the ILS industry is also keenly aware of the potential impacts from tariffs on US economic inflation rates and the cost of rebuilding after a nat-cat event.
“The cost of rebuilding after a cat just went up,” said a source.
On Friday, John Williams, president and CEO of the Federal Reserve Bank of New York, said he expected US inflation to reach 3.5%-4% this year because of tariffs.
For a typical residential property rebuild in the US, around 50% of the cost comes from materials and 50% is labour, according to Karen Clark, CEO of cat modelling firm Karen Clark & Company.
This would mean an overall inflationary impact of 5% on materials could lead to an approximate 2.5% increase in rebuild costs, as an example.
Clark noted, however, that the inflationary impacts of tariffs are likely to affect some types of property rebuild more than others, depending on the materials needed.
Typical materials needed for US residential property rebuilds include lumber (for wood frame houses), nails, steel (for high-rise/apartment blocks), concrete, tiles and plaster.
Currently, 25% import tariffs apply to steel, aluminium and automotives.
An additional factor, Clark noted, was people “building bigger, more expensive homes.”
She noted also that ongoing updates to building codes in states such as California and Florida could be expected to increase the cost of rebuilds.
With investors now adjusting to a higher base level of uncertainty, this generally points to a strong outlook for reinsurance risk takers, but the levels of unpredictability in the present US administration could bring unexpected challenges.