The biggest issues facing the insurance-linked securities (ILS) market today, all surround the terms and contractual language related to collateral lock-up and commutations, while loss buffer tables have been seen to cause particular problems as they are often too simplistic, speakers said at an event yesterday.
These issues all impact and affect the efficiency of investor capital that is deployed into the ILS and collateralised reinsurance market system, as overly simplistic terms can catch collateral that could otherwise have been put to more profitable use, becoming a drag on investor returns.
Speaking this week in London during a panel discussion held at the ILS Bermuda Beyond Convergence event, industry participants highlighted the issues that have become apparent in the ILS structure and the need for more work to be undertaken to ensure the same issues don’t arise again, where possible.
“The issue is capital efficiency and security for the ceding company,” Des Potter, Managing Director at GC Securities explained.
Adding that, “As a ceding company your security with a collateralised counterparty is as good as the money that’s sitting in the trust account. The contractual language is that as soon as that money is effectively released your security is diminished or gone.
“So, it’s very important that the contract language is very clear on the terms upon which you release that capital.”
The panel were discussing issues related to the catastrophe losses of the last few years, in particular the surprises thrown up by loss creep from events such as hurricane Irma and typhoon Jebi.
These events, as well as the aggregation of losses over multiple events and issues related to reserving, have all served to trap significant amounts of ILS investor and fund capital over the last few years.
Andy Palmer, Head of ILS Structuring, EMEA & APAC, at Swiss Re Capital Markets concurred, adding that this hurts investors ability to trade forwards, “The structures in which investors are often allocating have contributed to that.
“So, we have buffers which lock in more capital and result in really very disappointing returns. It’s all very well saying that in principal what’s happened here is that losses have happened, rates go up, now is the chance to double-down and take advantage of the situation. But if all your capital’s been locked up, it’s very difficult to do that.”
The structures are there for a reason but they haven’t always performed as desired or even expected, under the stress of unusual and challenging catastrophe loss events.
Palmer also said that the timing and magnitude of side pockets set have been another issue for investors, even resulting in some newer entrants not being as well-protected against prior period losses as they should have been.
Loss picks are challenging though as well, especially under complex or multiple event circumstances, but this has been hindered in some cases as structures have perhaps not been as well-suited, or thought through, as they could have been, exacerbating and accentuating impacts and drag from trapped collateral.
Potter took up the subject of drag on investment returns, saying, “The perspective from the investment side is that you want to make sure your capital is being used at all times, to enable you to deliver an adequate return to your investors. So, you want to make sure that every dollar of capital you invest in the sector is working for you, it’s not sitting in a trust account earning 2% on US treasuries, for example.”
As a result, Potter said, “It’s a difficult balance to strike, but recent events have probably shown that the loss buffer tables that are in most contracts are probably a little bit too simplistic and they’ve caused a lot of the issues with trapped capital, particularly on quota-share and aggregate deals.”
Brent Slade, President of Lodgepine Capital Management, the new retrocession focused investment manager owned by Markel, agreed that the terms around some of these collateral related issues have room for improvement.
Slade said, “I think as we sit here today, structurally within the market, the clawback, commutation, trust agreement language is probably the single largest issue that we have to address and rectify.”
Continuing to explain that this is a big reason that balance-sheets are attractive right now, “There’s a move by the capital market to affiliate with a strong balance-sheet and one of the primary reasons is to alleviate that potential for that sort of language to stay in the way of the efficient deployment and release of capital.”
Having access to a balance-sheet, in terms of a rated carrier or fronting, helps an ILS investment manager to “avoid that argument and imbalance between the cedant and the source of the capital,” Slade said.
“What we’ve done to address that, is that all of the risk that we deploy and write will be fronted by Markel,” Slade continued.
Adding, that this means for Lodgepine Capital Management, “That discussion, when it comes to the release of capital and any potential reserving is between us and our sponsor. As opposed to having to have conversations with cedants and relying upon an agreement that may be a little archaic and not necessarily addressing every single deal, and by that I’m referring to the commutation language and buffer loss tables.”
While the move to rated balance-sheets has been a big shift in the ILS market over the last few years, it’s not just to access new business, or more business, such as transactions that must have a reinstatement, it’s also to “address that issue with the language on release of trapped collateral,” Slade further explained.
Potter, coming from the broker side of structuring, arranging and syndicating transactions, said the market is working to address some of these issues.
“I think a lot of work is going on at the moment to try and solve that issue about capital efficiency, both from the security of the ceding company and the deployment from the investors side,” he explained.
Adding, “I think the end solution is going to come in the partnership between ILS capital and reinsurance balance-sheets.
“If a client demands reinstatement protection, or tail protection, over and above what may be adequate or capital efficient for a collateralised player, then a rated balance-sheet can provide that solution and get paid for it as well.
“It enables you to isolate the part of the risk transfer that works best in a fund strategy and the part of the risk transfer that is more efficiently deployed in a rated balance-sheet.”
As the ILS market moves to adapt and implement learnings from the last few years catastrophe-driven challenges, the business model and structures themselves are likely to adjust, resulting in a more resilient asset class to the benefit of both investors and ceding companies.