ILS fund side pocket strategies evolving for the better: Horseshoe’s Desmond

The insurance-linked securities (ILS) market and its fund managers are adapting their strategies following several years of heavy catastrophe losses, with their experiences in dealing with trapped ILS collateral driving them to evolve the way ILS fund side pockets are set and dealt with, Brian Desmond of Horseshoe told Artemis.

Side pocketing is a common practice in the hedge fund and investment management world and ILS fund managers have long used it to segregate potential loss impacted contracts from their main portfolios.

In simple terms, after a major catastrophe loss has occurred, ILS fund managers might analyse their portfolios to try and establish which investment positions or contracts could be affected.

Any positions identified as at-risk might be put into side pockets, or set aside (ring fenced) from the main portfolio while the loss event develops and it becomes clear whether the position is likely to face any loss of principle.

This can be a particularly complex and lengthy development process for some reinsurance and retrocession contracts, where information can be lacking. ILS fund managers have to use their expertise to analyse events and establish their own estimates for how portfolios could be affected.

The reasons for doing this are numerous, from ensuring that potential loss impacted positions don’t drag on the main portfolio, to trying to account for potential losses upfront and as early as possible, as well as to clean the fund of exposure to an event so that new investor capital can still be accepted into it, ensuring new investors and allocations aren’t exposed to legacy events.

But, the methods of side pocketing are varied in the industry, with managers adopting their own strategies. This has been stimulated by how complex some funds are becoming, in terms of their sophisticated and broad portfolio construction across globally sourced reinsurance risks.

This is now evolving for the better, according to Brian Desmond, Chief Strategy Officer and EVP, Head of Fund Services at Bermuda-headquartered insurance and reinsurance management and fund administration ILS specialist, Horseshoe, an Artex Company, as ILS fund managers have become increasingly sophisticated and effective at portfolio management and dealing with potentially distressed assets, based on learned experiences from past events.

To gain more insight into how ILS funds side pocketing strategies are changing after the recent years of loss activity, Artemis spoke with Desmond to find out how ILS fund managers are putting hard-learned experience into practice.

Desmond said that traditionally an ILS fund would look to side pocket an entire contract that has a chance of being materially loss affected after a large event

However, the industry is now putting its experience of the last few years to good use to improve its processes when it comes to side pockets and managing trapped ILS collateral, which Desmond said is resulting in “an evolution in this practice.”

Desmond explained, “We are seeing a clear change in approach, where ILS Funds are adopting a full portfolio view as opposed to side pocketing individual contracts.

“This can include setting up a side pocket with adequate reserves across multiple affected contracts to cover large events that occurred during a certain period of time, such as the last six months prior to the creation of the side pocket.

“Taking this approach provides the flexibility to side pocket either the entire contract or a buffered reserve across one or many different contracts. The result is a more efficient method of side pocketing ILS instruments and in most cases leads to less capital being removed/trapped from the main portfolio.”

Artemis reported last year how ILS funds had set up side pockets for potential COVID-19 business interruption loss affected assets, which was a particularly challenging scenario given the high level of uncertainty surrounding the pandemic.

Desmond agreed, saying, “Last year clients felt so much uncertainty and t a few clients decided to set up a whole new fund or create a legally separate share class with its own offering, while others stayed with the more traditional approach of using new series of shares to separate the affected parts of the portfolio.”

Desmond said that in the majority of cases, side pocketing can be and should be much simpler to achieve.

There are also cost savings to be had, depending on where an ILS fund is domiciled, Desmond said

“For clients using either Bermuda or Cayman as their fund domicile, the majority of funds are using series accounting and the ability to create a new series to accommodate side pockets is transparent in the relevant Fund’s Offering Document. As a result, there is not always the need to create a new class of shares or a new special purpose vehicle which can save on time and expense that would be incurred on legal fees to update documents and other burgeoning costs,” Desmond said.

“Taking a strategic and thorough approach to setting up a side-pocket remains the preferred approach,” Desmond said. .

Desmond said that it’s vital to ensure that the structure designed to facilitate management of side pockets and trapped ILS collateral meets the objectives of the scenarios expected to be experienced.

“The most common practice is to create side pockets around the key investor dealing dates, which for ILS funds are the January and June/July renewal dates. The rationale driving the creation of the side pocket is the protection of investors’ interests. As such, ensuring that a side pocket is created prior to investors entering or exiting the fund is paramount.

“As best practice, we do not encourage clients to set up side pockets every time a large event occurs if there is no investor activity and it is not a key renewal date. In these cases the administrative burden of creating a side pocket on investors, the fund and the fund’s service providers outweighs any perceived advantages,” said Desmond.

How management fees are considered, with respect to side pockets, has always been an issue of some discussion between ILS fund managers and their investors.

But, Desmond believes that managers need to still be compensated for side-pocketed assets, as it requires ongoing management and that the approaches to this are also evolving.

“In my view, the manager is justified in earning their management fee on the side pockets as they continue to work hard for their investors to both value the side pockets and to pro-actively work with cedants to generate liquidity over time. Calculating the fee based on the final value is a fair and conservative approach with which investors are comfortable,” Desmond said, adding that where performance fees are also a consideration, “Performance fees are generally not accrued in the side pocket account itself but are instead calculated as part of the performance fee calculation of each investor’s main class of shares after the side pocket values have been transferred back to the main series upon its closure.”

It’s one of the more complex pieces of the ILS fund manager’s jobs in managing ongoing in-force and legacy but potential loss-affected ILS and reinsurance assets.

Which makes the expertise of service providers key, in helping ILS fund managers ensure they have robust structures and practices in place.

But, it’s also key for the ILS industry that continued education and learning on matters such as side pockets sinks in, so strategies can continue evolving to service investors in the best way possible across a wide-range of loss scenarios.