Swiss Re Insurance-Linked Fund Management

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Collateralized ILS fund side-pockets set in wide 3% to ~30% range for Ian

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According to sources in the insurance-linked securities (ILS) investment community, side-pockets being established after hurricane Ian by ILS funds that invest in private deals and collateralized contracts, to segregate potentially loss affected investments, are ranging from as small as 3% to as much as 30% of a strategy.

side-pocket-ils-reinsuranceHurricane Ian has heavily impacted some insurance-linked securities (ILS) fund strategies and there remains some uncertainty over just how impactful the storm has been at this stage, given visibility is lacking when it comes to the more private ILS and collateralized reinsurance or retrocession focused strategies and there remains a wide range of industry loss estimates.

Hurricane Ian’s effects on the catastrophe bond market have been far more evident and documented, due to secondary price indications that have been received, as well as measures such as the Plenum CAT Bond UCITS Fund Indices that are calculated on a weekly basis and show a developing recovery since the hurricane hit.

With those data sources, we can gain a reasonable view of the effect hurricane Ian has had on the catastrophe bond market.

Originally they suggested an initial hit of as much as 10% for some higher-risk cat bond fund strategies, but then a recovery as some loss estimates came in and now the average decline has fallen.

Overall, as we wrote yesterday, the UCITS cat bond funds are down on average by 4.6% at this stage, some less and some more, depending on their risk-return profile, but with some further recovery in value possible over the next week or two.

There’s always less visibility of how ILS funds that invest directly into collateralized reinsurance, retrocession and other private ILS contracts have performed after a major catastrophe event and this is certainly the case after hurricane Ian.

We’ve tried to gain some visibility into this through discussions with a number of sources, including end-investors with allocations to specific strategies. It’s important to note, we don’t have visibility of the full range of ILS strategies and some of our information is anecdotal from ILS industry sources.

So far, these insights suggest a relatively wide-range, in terms of size, of the side-pockets that are now being prepared and established, as ILS fund managers look to segregate potentially loss affected positions from the rest of their funds.

Of course, this is only relevant to ILS fund strategies, or portfolios, where side-pocketing is the strategy followed to keep loss-affected positions segregated away from the main funds, to allow new capital to come in without any exposure to an event, while also allowing losses from a catastrophe event to develop to the side of the main fund portfolio.

From our discussions and ILS fund disclosures we’ve seen, there appears to be a very wide-range of side pockets, in terms of percentage of a strategy, being set after hurricane Ian.

Of course, this reflects the very wide range of risk-return profiles of ILS fund strategies, as the market has developed into a diverse one, where investors can target anything from low to mid-single digit returns, to returns that are well into the double-digits.

One ILS fund disclosure we’ve seen describes the uncertainty over valuations of some positions in its collateralized reinsurance portfolio after hurricane Ian and so the need to segregate those, while loss estimates settle and a valuation can be gained.

That manager’s ILS fund strategy, one a number it operates, has been side pocketed around the 25% mark we understand.

As side pockets are set, investors effectively hold a claim against the original ILS fund and the side pocket, in proportion to their stakes.

Once greater valuation certainty emerges, side pockets can be returned to the fund, or remain segregated, depending on how affected they are by losses.

In some cases, if side pocketed ILS investments are expected to become a total loss they may remain segregated for ease, but we’re told that, in the case of hurricane Ian, a return of some capital to the main ILS fund strategies is anticipated, as manager’s seek to set sufficient reserves to provide a buffer that they expect could prove additional to losses that actually get paid.

We’ve seen disclosures from a more collateralized retro reinsurance focused ILS fund that is side pocketing as much as 30% of some portfolios it manages after hurricane Ian, while some higher-risk reinsurance focused funds with a more significant Florida leaning are also set to side-pocket close to that amount.

On the opposite end of the spectrum, we’ve seen disclosures related to the lower-end of the collateralised reinsurance fund volatility level, with ILS funds that typically target mid-single digits to low double-digits in some cases only having to side pocket a relatively small amount, up to ~5%, or not even needing to side pocket at all as the impacts are deemed manageable within the main fund portfolio and clarity on losses is expected more quickly due to the cedents affected.

For these ILS funds and their managers, the fact losses from hurricane Ian are set to fall within the annual returns of their strategies could position them particularly well for 2023, given more of their capital will remain available for the renewals, to take advantage of hard market conditions, but perhaps more importantly to provide continuity to their counterparties.

The ILS fund structure and mechanism for managing exposure to major catastrophe losses appears to be working well, in the case of hurricane Ian.

But, perhaps more importantly, there is some evidence of ILS funds, that invest in reinsurance, retro and collateralized products, reporting lower than expected exposure to an event the magnitude of hurricane Ian.

Part of the reason for that could be the work put in over recent years by ILS managers to better insulate their portfolios to loss events in peak zones like Florida, but also the tightening of terms and conditions, as well as the higher rates underwritten at, are also set to show as improvements in peformance after an event such as Ian.

Of course, there are also some with what appear outsized exposure and we understand some strategies are facing locking of collateral to such a degree that it equates to more than 30% of a strategy held.

ILS managers deal with such exposure in different ways, with side pockets just one tool at their disposal.

For the end-investors, what will be key is understanding how side pockets develop, so communication from ILS managers will be key to help investors stay abreast of their potential losses from hurricane Ian and to quickly understand any worsening of the outlook, or any improvements and expected returns of segregated assets and capital to the main fund portfolio.

There is every chance some ILS fund strategies with investments into collateralized reinsurance and retro find their reserves are set higher than needed, as hurricane Ian’s claims process plays out. In fact, most manager’s will be trying to ensure they reserve, or side pocket, ample to cover expected loss impacts.

Inflation, litigation and loss amplification remains the great uncertainty though, given this is Florida and the ILS market’s memory of 2017’s Irma remains very fresh.

So it may be some time before clarity over hurricane Ian side pockets and how sufficient they are becomes available.

Register today for ILS NYC 2023, our next insurance-linked securities (ILS) market conference. Held in New York City, February 10th, 2023.

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