First rating criteria for insurance-linked funds proposed by A.M. Best

Rating agency A.M. Best has published and is seeking comments on a new draft rating criteria which we believe to be the first to specifically target insurance-linked funds, including those investing in catastrophe bonds, ILS and collateralized reinsurance.

The move marks the first time that A.M. Best has targeted insurance-linked securities (ILS) funds directly with a rating criteria, which perhaps shows the increasing importance of ILS funds and their growing influence in the reinsurance sector as sources of capacity.

Currently A.M. Best does not rate any existing ILS funds but in the future it looks like it will be able to as required, either on request or if it was to deem it necessary. With ILS fund managers growing their assets and some ILS funds commanding significant sums of reinsurance capacity it seems A.M. Best now feels they are prevalent enough to warrant rating attention.

A.M. Best is now seeking comment or feedback from market participants and any interested parties on the new draft criteria report, titled “Insurance-Linked Fund Ratings.”

The rating agency says that an A.M. Best Insurance-Linked Fund Rating (ILFR) is its opinion on an insurance-linked fund’s (ILF) average credit quality and vulnerability to losses due to:

1. credit defaults in a portfolio constituted primarily of insurance-linked assets; and
2. the inability of the fund to fulfill specific and direct contract obligations associated with insurance-linked assets, if such obligations exist.

A.M. Best says that the Insurance-Linked Fund Rating’s are fundamentally different from the more typical issue or issuer ratings because funds generally cannot default on obligations, since they essentially have investors who own shares and can only participate in losses or gains associated with the funds.

The rating agency explains that a rating for an insurance-linked fund does not make any guarantee about the fund’s performance and is not intended to make any statements about the net asset value that investors should expect or regarding the level of fees charged by a fund’s manager.

The draft rating criteria is designed to cover many types of insurance-linked investment funds, including those investing in the following types of insurance-linked assets or obligations: natural catastrophe bonds, industry loss warranties, extreme mortality bonds, surplus notes, trust-preferred securities, structured settlements (of both the period-certain and life-contingent varieties), ordinary annuities, life settlements, Regulation XXX/AXXX securities, collateralized debt obligations backed by insurance-related risks, and other insurance-linked assets, obligations and structured securities.

A.M. Best’s draft criteria is designed to cover any insurance-linked funds which invest across different classes of business, such as ILS funds which allocate to both catastrophe risks and mortality risks, although the rating agency notes that these are rare at the moment. However as the sector grows this will allow flexibility in the rating process as ILS funds branch out to cover multiple classes of reinsurance business.

The draft criteria goes into some detail on the process that A.M. Best proposes using to rate ILS funds, including the default matrix, how it would rate funds holding assets with a default probability of attachment and without, how concepts such as fair values or term to maturity applies, what type of assets it would expect to see in insurance-linked funds and more.

Clearly we’re most interested in the ILS and reinsurance-linked funds rating proposals, on which A.M. Best says:

The ILFR of collateralized reinsurance (including industry loss warranties, sidecars and catastrophe bonds) depends on the attachment probability of the natural catastrophe occurring and the likelihood that components of the collateral will default. A.M. Best expects the collateral in such transactions to be of the highest level, so it may not contribute much to the credit risk tabulation of the collateralized reinsurance. However, A.M. Best will need information about the collateral and whether there are any swaps involved to maintain its value. The fair value, term and attachment point of the individual holdings in the transaction are used in determining the ILFR for the transaction.

A.M. Best expects the aggregate credit profile of the assets in funds that invest primarily in natural catastrophe risk to be below investment grade for the following reasons: 1) the individual credit profile of the fund components as measured by the first dollar of loss most likely will be below investment grade, and 2) the correlation among fund holdings likely will be high, since diversification is hard to achieve with natural catastrophe risk.

It is important to note that the ILFRs for funds that operate at or near “working layers” with high attachment probabilities may in fact compensate investors for the risks they are bearing, but A.M. Best only uses attachment/default probabilities in its analysis, not expected losses or premiums paid to the funds for undertaking such risks. For natural catastrophe funds, adjunct measures such as loss volatility or premiums compared with expected losses may be more appropriate and useful for investors. In the future, A.M. Best will explore alternative measures of risk for such funds that can complement the aggregate credit quality measure.

Because the results of attachment probability calculations can vary greatly depending on what options are activated in peril models, A.M. Best expects any information it receives about modeled attachment probabilities to include activation of the following options:

• Warm sea-surface temperature condition and storm surge modeling for wind exposures;
• “Fire following” for earthquake exposures;
• Demand surge conditions (which considers the increase in replacement cost); and
• Secondary uncertainties to reflect the volatility around mean loss numbers.

So this could be very important for ILS funds, as the sector continues to grow and more ILS funds or ILS managers launch and so competition increases.

As the sector becomes more saturated with fund offerings, one of the ways that investors will be able to evaluate insurance-linked funds in the future will be through a rating and this is the first rating process that we are aware of which has been proposed specifically for ILS, insurance-linked, catastrophe and reinsurance funds.

As such we’d suggest that it is important that any interested ILS market participants, ILS fund managers, ILS investors or those considering entering the sector read the full draft criteria and provide comments or feedback to A.M. Best in a timely manner. Comments are requested by October 29th 2014.

You can access the draft rating criteria titled ‘Insurance-Linked Fund Ratings’ here.