Notable in the wake of Hurricane Irma in 2017, trapped collateral is an ongoing issue for the insurance-linked securities (ILS) space. But through tools available within the capital markets, funds can manage extensions and put an end to non-performing assets.
This is the view of Cedric Edmonds, founder of Replexus, an independent marketplace for insurance risk securitisation, and service provider to the re/insurance, broking, and ILS sectors.
We spoke with Edmonds, a reinsurer by background who has been active in the ILS marketplace since 1999, around the launch of his new whitepaper, which discusses the need for ILS funds to ever have non-performing assets – a trend driven by trapped collateral post-catastrophic events.
“Non-performing assets within an ILS portfolio are typically to be found in the portfolios containing so-called illiquid ILS or more correctly collateralised transformed reinsurance. Cat bonds always pay a coupon, albeit for off-risk periods (e.g. pre-risk-inception, post-risk-expiry or if the bond is held in extension) such coupon may be low.
“When collateralised reinsurance goes into extension typically no additional premium is payable during the extension period,” explained Edmonds.
With any ILS investment, the hope for both the ILS fund and investor is that there’s no loss so that the collateral can be released and re-deployed.
But of course, in the catastrophe risk transfer universe, losses do happen at some point, and when an event occurs that is known to trigger the total loss of a collateralised reinsurance contract, it’s straightforward – the value of the investment falls to zero.
But when the reinsured has a loss that is not yet sufficient to trigger a total loss of a contract but is large enough to keep the collateral within it outstanding, the trapped collateral problem arises.
Using a one-year ‘zero-coupon’ investment that pays a rate-on-line of 10% as an example, which excluding any costs and risk-free return would be expected to rise to 110 linearly over the year of the contract, Edmonds explains that, in the above scenario, “we now have a non-performing asset, an asset that pays no coupon nor does it increase in capital value.”
The issue is that during the extension period, if the ILS fund is convinced that the collateral will return in say 6 or 12 months, for this extension period it might maintain the value of the asset at 110, which Edmonds argues is wrong.
With this example, there is no bid on this position as it is illiquid and private but were it able to be traded during the extension period, Edmonds says it would be unreasonable to assume a bid at 110, as no investor would purchase an asset for 110 which redeems at the same price in 6-12 months.
“Funds need to, at the very least cover their fees, fund running costs and some sort of return for their investors. The floor in the ILS space is typically an annual return of 2%,” he said.
Edmonds’ example is based on the investment redeeming at 110 at a future date, but the reality isn’t so straight forwarded, as there’s always a chance the loss will increase during the extension period and drive a loss to the relevant layer. This could result in a redemption at say 50 or even zero.
So, the true value of the asset may be considerably less than the 110, maybe only 90, explains Edmonds.
“At 90, after the write-down we have a very performant asset, one that even performs better than the original investment,” said Edmonds.
“If there is such an overvaluation (110 instead of 90) the impact on remaining fund investors when investors leave and on new investors joining is much more significant. It is further enhanced by the fact that if a fund has a single contract in extension, it is likely that a significant catastrophe event has occurred and say 10-20% of the portfolio may be affected.
“The impact of this effect has been seen with certain funds when late reporting of losses, in particular Irma. New investors post Irma found themselves paying Irma losses and investors who redeemed after Irma made an excess return that they shouldn’t have,” he continued.
In Edmonds’ mind, this valuation can easily be solved by turning these illiquid positions into liquid, tradeable positions, where they can be priced in the market and sold.
“Fund managers would likely rather this did not happen because as soon as the position has a ‘low bid’ they must mark it down. For the investors though it allows them to leave and join the fund at the correct price, to receive cash instead of ‘side-pocket’ shares and finally to have a book where all of the assets are performing month on month.
“Also, it improves the comparison of fund performance; investors would know that performance is actual and not based on hopeful valuations,” said Edmonds.
It’s not all bad news for the funds, though, as once the position is marked down managers can elect to either ride the price back up or sell it for cash and invest in new un-encumbered transactions, or even start a distressed fund to take these positions from their funds and potentially third-party funds, noted Edmonds.
Expanding on this, he explained that “Distressed funds have a distinct advantage insofar as they do not correlate with the existing ILS funds (deterioration on Ian is uncorrelated with the occurrence of a hurricane in 2023), and equally they do not correlate with the greater capital markets. In effect it becomes a second uncorrelated asset class for ILS funds to sell to their investors. It keeps the forward- looking ILS funds clean of run-off risk whereas investors in the distressed funds are well aware that they are taking the deterioration of Ian, Irma, and others, so the ‘investor issues’ with late-reporting go away.”
The development of a distressed marketplace, according to Edmonds, is another step in the Lloyd’s direction for ILS funds and would be similar to reinsurance-to-close in the traditional market.
“Creating a market around it, trading and having price-discovery further enhances the mechanisms,” said Edmonds.
“I would therefore conclude that NO! ILS funds should never have non-performing assets and, by using capital markets ‘technology’, ILS funds can deal with extensions and in doing so improve their offering to both investors and cedents alike,” he concluded.
Read the full whitepaper here.
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