Private contracts see ILS fund exposure to frequency events growing

by Artemis on January 25, 2016

Private ILS contracts and collateralised reinsurance arrangements entered into by ILS investment managers mean that ILS fund exposure to frequency events is on the rise, while the range of perils they are exposed to is also increasing.

The growth of collateralised reinsurance and private ILS transactions has been impressive over the last two years, now estimated to have grown to $32 billion of the $68 billion ILS and convergence capital market by broker Guy Carpenter.

As this segment of the ILS market has grown, which has helped ILS managers to broaden their participation in global reinsurance markets, there has also been a steady increase in the sectors exposure to frequency-type events and to new perils or regions.

In the last few months this has been even more evident as a number of ILS funds have reported potential exposure to events such as the UK flooding, an Australian bushfire and severe weather in the U.S., while earlier in 2015 storms in Australia, the Tianjin port explosions and Chile earthquake all negatively affected some ILS funds’ net asset values (NAV’s).

As well as the broadening of exposure, into specialty classes of risk and other regional perils, the growth of private contracts and collateralised reinsurance is also increasing the likelihood that frequency events, or an aggregation of losses, can hit ILS fund investors.

“The widespread nature of private contracts means losses can be incurred even in absence of major events. This is in line with our observation that some private ILS funds suffered losses from regional and frequent events,” Stefan Kräuchi, founder of ILS Advisers, said recently.

In reporting on performance for the Eurekahedge ILS Advisers Index in November, Kräuchi said that one ILS fund reported a negative return for the month and this was; “Due to its loss on aggregate covers in Australia.”

“As private ILS funds are taking on aggregate covers, they behave differently compared to pure cat bonds funds,” Kräuchi continued.

“Private ILS funds will become more and more vulnerable to frequency events while pure cat bond funds are still mainly vulnerable to severity events. Recent winter storms and flooding in UK caused losses over GBP 1.5bn. Some ILS funds reported incurring attritional losses to the portfolio,” he said.

This is again further evidence of the continued expansion of the ILS market, with private deals and an increase in aggregate exposure meaning that some ILS funds are increasingly exposed to frequency events, or an aggregation of smaller loss events, rather than just the very large severity-type catastrophe events.

However, this expansion is seen as a real positive for the ILS space and investor community, providing additional opportunities for diversification, an ability to enhance yields and generally more choice in terms of strategies and risk appetite.

Kräuchi explained how private ILS deals can help with portfolio construction; “On a positive note we have observed that the performance of funds also allocating to Private ILS is a lot less homogeneous than performance among pure cat bond funds. In other words the correlation among Private ILS funds is significantly lower than among cat bond funds. That is especially helpful in the portfolio construction because it means that investors can achieve more diversification benefits by investing in a portfolio of private ILS funds than by allocating in a portfolio of pure cat bonds funds.”

Essentially, by investing in private ILS transactions or collateralised reinsurance, as well as catastrophe bonds, an investor can ensure a broad spread of the market return is achieved and can also access a much broader set of risks and opportunities.

Kräuchi continued; “Private ILS funds are not only able to access a more diverse range of risks (Emerging markets, global coverage) that are not accessible through cat bonds but can also achieve higher granularity in terms of counterparties through local insurance companies. Moreover private ILS funds have many degrees of flexibility in terms of strategies, perils, type of contracts geographies and layer of risks taken.

“Private ILS funds also have an extensive range of deal sources: they can get access to transactions through different channels such as reinsurance companies, brokers, Lloyd’s market, local insurers or even direct insurance.”

So while the exposure expands with private ILS and collateralised reinsurance it can be controlled through diversification and type of strategy, concentrated or otherwise.

But, as this exposure continues to expand, with the private ILS contract segment of the market perhaps the fastest expanding thanks to collateralised reinsurance, investors in ILS funds will have to get used to seeing more frequent, although likely minor, losses reported.

Still, ILS fund managers tend to participate in these private ILS or reinsurance contracts at levels where it does take a more significant loss to really hurt their portfolios. Additionally, a lot of the new perils or regions being added are in small volume, meaning that losses to those positions tend to be minor across an ILS fund’s NAV.

But expand further into insurance and reinsurance the ILS fund sector will, and overall this is a promising trend, as for investors the ability to invest in a range of ILS funds and manager strategies, across risks, perils, severity, frequency, levels of attachment and types of structure, will increase. And over time that will provide more options for large investors to diversify their allocations within the ILS sector.

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