Should more insurance-linked securities (ILS) funds adopt more transparent fair value accounting a more transparent and liquid market could develop, that would ultimately lead to further expansion of the sector, according to Bill Dubinsky, Head of ILS at Willis Capital Markets & Advisory (WCMA).
Dubinsky explains that fair value accounting “attempts to capture a market value at a point in time.”
“Conceptually, fair value accounting allows for the expected value of future cash flows, discounting, and adjustment for risk, counter-party credit risk and market conditions.”
In a report Dubinsky explains that typically traditional reinsurance companies and sidecar type vehicles utilising insurance GAAP accounting, property reinsurance agreements are not held at fair value.
ILS funds are subject to fair valuation accounting requirements explains Dubinsky, but this can very greatly depending on the type of investment.
He suggest that the quality and consistency of fair valuation accounting within the ILS space is something that needs to be improved, noting that this could create a more transparent market that would ultimately lead to growth for the sector.
“More accurate fair valuation makes it less likely investments and balance sheets collapse like a house of cards,” said Dubinsky.
The key benefit for ILS funds that accurate fair valuation brings is the ease for investors in the space to enter and exit a fund at a “fair price for the risk they are bearing,” said Dubinsky.
Enabling greater transparency and allowing investors fairer entry/exit from the market would likely increase investor comfort and acceptance of the asset class, something that is also key to expanding the sector.
Furthermore, Dubinsky notes that ILS funds that deal with illiquid reinsurance-linked investments, fair value accounting practices may not be correctly applied.
“A common example is treatment of unrealised gains or losses on contracts with aggregate deductible features depending on the erosion to the deductible. So some investors may be valuing illiquid investments linked to private reinsurance more like reinsurers booking reinsurance,” explained Dubinsky.
The result of differences in ILS funds applying fair valuation to illiquid private securities and the variables in investment selection (liquid/illiquid investments), suggests ILS funds “with more collateralized reinsurance investments show differentiated returns and less month-to-month portfolio volatility than peers using other either inconsistent valuation approaches to illiquid investments or holding relatively more liquid bonds,” said Dubinsky.
What’s more, “those same ILS funds have potentially less accurate portfolio valuations than their peers making entry/exit less fair,” stressed Dubinsky.
Dubinsky notes that this points to a general need for greater transparency in the sector and more liquid investments, such as tradable bonds, which in turn could lead to growth for the sector.
He explains that “if a push towards transparency leads to increased bond issuance, the resulting increase in liquidity would make it possible for mutual funds, which place a much higher premium than pension funds on liquidity for its own sake (rather than simply for increased accuracy in valuation) to continue to grow their assets and impact in the reinsurance space.”
ILS market investors such as pension funds are increasingly sophisticated and mature about the space. And as the market has continued to grow and broaden its scope, it’s resulted in the need and desire from investors for greater risk information and modelling capabilities from ILS funds and ceding firms.
A move in the same direction with fair value accounting and increased market liquidity would ultimately lead to greater market transparency, says Dubinsky.
“In contrast to a potentially foggy future of illiquidity and intransparency, we may be on the cusp of even more growth in ILS if robust transparent fair value accounting becomes more common,” concluded Dubinsky.
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