ILS market can mitigate convergence risks with discipline: A.M. Best

As the convergence market continues to further integrate and deepen its relationship with the traditional reinsurance and primary insurance industry, ratings agency A.M. Best has warned of potential risks to the growth of insurance-linked securities (ILS), if not properly managed.

As the understanding of ILS products, including collateralized reinsurance, ILWs, catastrophe bonds, sidecars and so on continues to increase, coupled with advances in risk modelling platforms resulting in a growing acceptance of such risk transfer through these structures, naturally, so to will potential risks and regulatory/rating concerns.

“A whole host of concerns and emerging risks may manifest and impact the convergence market as it grows,” notes insurance and reinsurance ratings agency, A.M. Best.

Continuing to list, in its recent publication “It’s not Your Father’s Reinsurance Market Anymore” – The New Reality,’ the risks it believes pose a threat to the expansion and evolution of the convergence market.

“These include basis and tail risks; collateral/counterparty risks; legal risks associated with the formation/legitimacy of special purpose vehicles and segregated cell structure; and the true potential value of the notional balances of parental guarantees by insurance and non-insurance entities acting as counterparties,” highlights A.M. Best.

The basis risk, defined as the risk that a re/insurer won’t receive adequate recoveries from a product in relation to their actual loss from an associated event, “is one of the key regulatory and rating concerns as the number and amount of ILS transactions continue to increase,” notes A.M. Best.

Basis risk is more of a concern with ILS instruments that use a non-indemnity trigger notes A.M. Best, which, has been limited in recent times by A.M. Best’s own observation that, within the cat bond market, indemnity trigger use has far outpaced non-indemnity triggers in the last three years.

But regardless of this, A.M. Best underlines that its reasoning for estimating a basis risk relates to determining the volume of reinsurance credit that “should be given to non-indemnity ILS instruments in Best’s Capital Adequacy Ratio (BCAR) analysis.” Something the rating agency says is an integral part in assigning re/insurance firm ratings.

While the basis risk might be an inherent part of risk financing products and structures, it does suggest that companies with a significant basis risk are perhaps not correctly or adequately managing their exposures.

Furthermore, the rise of indemnity triggers in the cat bond space, which A.M. Best suggests mitigates the potential of a negative basis risk, are easier for sponsors to understand than say a modelled loss or parametric trigger, which likely in part contributed to the triggers recent rise.

Robust risk modelling, disciplined underwriting and sound understanding of exposures will naturally reduce a company’s basis risk potential, and these are all things that one would hope convergence market participants are already doing on a consistent basis.

In fact, with ceding companies rationalising their reinsurance coverage over recent years, many are gaining a new appreciation for triggers such as parametric, or industry loss, as they find that taking a step back, restructuring their programs can provide the information to enable these tools to be better fitted into their risk transfer.

In fact, if approached in the right way and with the view of hedging or transferring risk, parametric triggers in particular should not be viewed as having a basis risk. The idea is that they pay out under specific circumstances, not exactly match a loss. Perhaps the real issue with basis risk is how these non-indemnity products have historically been sold to cedants?

The same can also be said about the tail risk, being the risk “borne by the insurer or reinsurer, the original sponsor of the transaction, if the ILS instrument is insufficiently capitalised to absorb losses and the risk assumed to be fully hedged by the ILS instrument may ultimately be borne by the sponsor,” explains A.M. Best.

Adequate catastrophe modelling adoption, and sound underwriting practice to enable a comprehensive view of the exposures and potential risks, should contribute in minimizing the tail risk of a portfolio.

As an example, the report draws on sidecars, another element of the convergence market that has gained momentum in recent times.

“In the context of sidecar transactions, tail risk refers to the risks that will have to be borne by the sponsor of the sidecar if the sidecar is not sufficiently capitalized to support the reinsurance transaction,” explains the ratings agency.

Typically, reinsurance sidecars are fully collateralized vehicles, meaning that if sound, comprehensive risk assessment; modelling and prudent underwriting discipline is embraced, the amount of capital in the structure should adequately reflect the potential amount of losses, including those that deviate from the expected.

Again, this suggests that a sidecar was established as a tool to replace a standard reinsurance contract. These ILS structures need to be brought holistically within the reinsurance program, not added as a hoped-for direct replacement. If the program is built from the ground up to incorporate responsive trigger products and structures like sidecars, the basis and tail risk issues can be greatly minimised.

Regarding legal risks the report notes that although the potential is minimal, differing regulations surrounding the use of special purpose vehicles or insurers (SPV’s or SPI’s), a hallmark of the convergence markets, means that legal issues are always going to be a concern, but again, increased understanding globally about the workings of such structures should further mitigate this.

There are now so many specialist law firms, administrators and accounting firms, with deep working knowledge of the SPV structures, that these legal issues can again be greatly minimised through working with the right partners.

Another concern for the growth of the convergence market according to A.M. Best is with collateral and counterparty risks, highlighting the default of four cat bonds in 2008 owing to missed repayments. But again, as the understanding and acceptance of such structures continues to spike so to will improvements in reducing collateral risks. Without full collateralization, notes the report, “collateral and counterparty risks cannot be discounted.”

Of course the Lehman issue in 2008 was responded to be the ILS and cat bond market, which changed from a total return swap counterparty collateral approach to a fully-funded trust filled with Treasuries and money market funds, a much more secure form of collateral.

The final risk to the growth of the convergence markets underlined by A.M. Best is with parental guarantees, relating to the fact that insurers and reinsurers’ in the use of fronting arrangements isn’t uncommon.

Owing to this, it’s “next to impossible to assess the true notional balances of parental guarantees in cases where guarantees are involved and may even pose a hidden systematic risk for reinsurers in case of catastrophic events of monumental proportion,” said A.M. Best.

So clearly there are risks to the expansion and continued development of the convergence market meaning that “A.M. Best is increasingly looking at how insurance-linked securitization can affect the ratings of the insurance companies it evaluates.”

For insurers and reinsurers risk is the name of the game, and in a market where relevance is becoming ever more vital to survival, you would hope the majority of firms involved in the convergence markets are doing there utmost to help the sustainable growth of the sector, with intelligent and disciplined underwriting coupled with innovation.