Covid-19 to reduce ILS capacity, trap collateral: Redhead, Lancashire

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The impacts of the Covid-19 coronavirus pandemic will be felt broadly across the global reinsurance marketplace, but in the insurance-linked securities (ILS) market the effects may drive a reduction in available ILS capacity and trapping of collateral, Darren Redhead, CEO of Lancashire Capital Management said today.

darren-redhead-kinesisSpeaking during the quarterly earnings call for parent company specialty insurance and reinsurance group Lancashire Holdings Limited, Redhead explained that the level of uncertainty surrounding the eventual ILS market impacts of Covid-19 is significant, but impacts will be felt.

“It’s an ongoing event and will continue to be evaluated,” Redhead explained.

Going on to give an overview of how the ILS market may be affected over the coming year, “I think there will be reduced capacity in the ILS sector and traditional sector for reinsurance, which will all cause pricing increases.

“You will see redemptions where people are trying to ease liquidity issues, from other types of assets. There will be redemptions or liquidity issues where people have used leverage, a fronting carrier.

“So there are a number of issues really that will come through and then you’ll also have the issue of trapped capital as we go through the coming months and quarters.

“One thing you can be pretty certain of, there will be less capacity.”

It won’t all be about a shrinking of available ILS assets though and there are likely to be some third-party investors that want to upsize their allocations, or that find the current market conditions and the returns on offer appealing to begin allocating capital to an ILS fund or strategy.

Redhead continued, “There will be investors looking to come in, and it will be on what basis do they come in, obviously they will want more money and reduced exposure, but that’s all to be determined as we go through the coming months.”

Asked about the potential for there to be claims from property towers due to business interruption caused by the pandemic that fall to ILS market players, Redhead said it’s still too early to understand the magnitude of this exposure.

“The vast majority of claims in the property section are going to be from BI. So it’s really going to depend on the quantum coming from insurance through to reinsurance and how far up they extend.”

But the uncertainty surrounding the potential exposure to business interruption, whether or how claims may flow through from property insurance towers, into the reinsurance, retrocession and perhaps ILS market, is particularly significant with what is an unprecedented industry loss event, making it very hard to provide any idea of the quantum of exposure at this time.

As well as making it a challenge to put a number to the size of the ILS market’s exposure to Covid-19, it’s equally hard to understand how trapped capital could affect the sector from the pandemic exposure.

But as counterparties to the ILS market begin to identify their own exposure to business interruption and the risk of their property insurance or reinsurance portfolios being affected, they are likely to look to hold onto their protection while the quantum of loss is identified.

Redhead commented, “Like any loss, if it’s a covered event and the counterparty thinks there’s a possibility of there being a claim, normally at around half the deductible, I would expect the customer client to trap the funds because they’re unsure of whether they are going to have a claim or not.

“So, for a vast majority of them where they think there’s a covered claim, I would expect there to be trapping.”

We’ve highlighted this risk facing the ILS market in a couple of recent articles.

Covid-19 could have a particularly long-tail for the reinsurance industry, which has bearings for insurance-linked securities (ILS) exposure, given the potential for collateral to be trapped for long periods if that proves to be the case.

The tail of a pandemic loss event and one drawn out by litigation will also have a bearing on ILS funds, who may find collateral trapped for a long-time, even on treaties and reinsurance arrangements where pandemic coverage had never really been envisaged.

Some collateral could be held while litigation rolls on, adding a new social inflationary dimension (a true litigation risk) to this global industry loss event that is quite unlike most catastrophes (natural or otherwise) experienced before.

With the potential for some insurance-linked securities (ILS) fund collateral to be trapped over Covid-19 potential claims, the litigation risk and uncertainty around wordings may lead to creeping collateral retention requirements as well, which would not be a good situation to get into for driving investor confidence.

All of which serves to further underline the unprecedented nature of the loss event facing the insurance, reinsurance and ILS community.

Redhead said that it will take time for this to all manifest itself in the marketplace, with discussions as far away as for next years 1/1 renewals likely to see discussions about what the quantum of Covid-19 exposure really is for clients.

On the Lancashire Capital Management collateralised reinsurance strategies themselves, Redhead said the unit would be following its parents methodology on reserves for any potential loss exposure.

“It all depends on what your view of the event is within your reserving. We reserve as the group does. So if we were of the view that the contract had the loss, irrespective of trapping, we would mark that contract as a loss,” he explained.

Also read: Lancashire expects continued risk pricing improvements: CEO Maloney.

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