While the immediate economic and financial market impacts of the Covid-19 coronavirus pandemic have ramifications for investor appetite, there are longer-term reasons that ILS funds could face challenges when it comes to accepting new inflows while the virus remains prevalent.
For insurance-linked securities (ILS) funds and other collateralised reinsurance investment strategies, the immediate fall-out caused by the pandemic has been evident changes to investor appetites and priorities.
With global financial markets having fallen dramatically and continuing to be very volatile, some of the more generalist institutional investors in ILS have taken advantage of the asset classes relative lack of correlation to the falls in equities and other assets to cash-in their holdings in catastrophe bonds or to request redemptions from ILS fund managers.
It’s not just the more generalist investors looking to redemptions either, as we understand some larger institutions are also seeking to down-size ILS allocations as a way to shore up their own capital and to free cash for reinvestment into other opportunities right now.
The market declines driven by the coronavirus have created significant opportunities for those able to spot them, meaning investor priorities are changing at this time and for some the stable less correlated returns of ILS may not be as attractive as the opportunity to invest in severely depreciated assets.
As we explained last week, the ILS market and broader reinsurance faces challenges in recapitalising at this time, due to the evident contagion risk across asset classes seen as the coronavirus pandemic took hold.
But it goes further than this as well and the significant uncertainty that the pandemic has created may also have implications for the ability of ILS funds to easily accept new inflows, without making some structural changes to allow for fresh capital injections from existing investors, or new investors, to enter their strategies.
The problem lies in the potential exposure of some ILS funds or collateralised reinsurance strategies to business interruption and related claims from the pandemic, even when they do not invest directly in lines of business that are explicitly exposed to losses.
While claims are clearly being seen in lines of insurance and reinsurance business such as contingency, event cancellation, trade credit, travel and aviation, there are efforts underway to try and force claims through into areas such as property insurance, with clear ramifications for some ILS players if those efforts prove successful.
Some leakage of claims into property policies and the like was always going to be seen, as wordings and exclusions have often not been set robustly enough to ensure there is absolutely no chance of pandemic exposure.
The uncertainty created by what is now almost a litigation or political risk related to pandemic business interruption and shutdown claims will make it incredibly difficult, perhaps impossible, to accept new capital inflows into ILS funds or reinsurance investment strategies that carry any risk or exposure to the ongoing action being seen around the world.
It’s a common practice of the ILS fund manager community to insulate investors against any potential exposure to prior events. This has been achieved through the use of side pockets, to take impacted or distressed assets out of portfolios, as well as through the issuance of new share classes in funds to segregate new investors from risks the older investor base are facing.
While the Covid-19 pandemic hasn’t yet driven any claims through to the ILS market of significant note, just the fact that it could do (no matter how slim) may mean that ILS fund managers have to prepare themselves for some structural re-organisation of strategies, in order to accept new capital into them.
ILS funds are going to have to find the best way’s to achieve this, a segmentation or segregation of their fund strategies to enable more capital to flow in but be protected from the pandemic and any claims resulting from it.
The solution will likely differ depending on the strategy.
For a vehicle like a collateralised reinsurance sidecar, which are typically annual in nature, or an ILS fund designed to run for just one-year, the next sidecar will not have any exposure to the pandemic, so that is simple and requires little extra management effort except perhaps just ensuring there is no legacy exposure contained within. Sidecars are an area to watch for potential claims exposure, we believe.
But for ILS funds and structures that roll forwards and underwrite across each renewal, or opportunity, throughout the year, adding new contracts and exposures as they go, something may have to be done to bring in new capital while the coronavirus uncertainty on claims remains heightened.
This could be achieved through a drastic side-pocketing of every asset in the ILS portfolio that has any potential exposure to the pandemic, to achieve a segregation and to protect the new inflows of capital or new investors.
Or the structuring of a new share class for a fund, that has specific exposure to the existing portfolio excluding any assets that could be at-risk of coronavirus claims, would be another way to achieve the same goal.
But either way, or through some other structural solution, the end-result could be an ILS fund market where strategies are becoming more split by underwriting years, or where there are two distinct strategies exposed to the same year. All of which will increase management effort and the need for oversight.
Until the litigation risk associated with the coronavirus pandemic is removed, which may require government action to be put in place to backstop the majority of claims, this uncertainty is likely to hang over portfolios of reinsurance and retrocessional risks that could carry some exposure to it.
It’s important to think more broadly than just the United States as well, as even though that is seen as the epicentre of the litigation surrounding pandemic claims there are also some fears over reinsurance contracts in some areas of Europe, Japan and likely other regions of the world where pandemic exclusions didn’t exist or weren’t so well worded.
The key is in making sure capital is not exposed to risks or events that have already occurred but where litigation and uncertainty could cause eventual claims to develop against the portfolio.
Investors need to be confident in their fund managers ability to protect them and it will be interesting to see what solutions the ILS market creates to negotiate this uncertainty, as well as how different ILS manager infrastructure (such as rated balance-sheet entities) plays a part.
As we said at the start, given the similarity to dealing with loss exposed portfolio positions using side-pockets, it seems ILS fund managers should be able to deal with this uncertainty effectively. But the longer-term pressure of having to hold a portfolio open, if litigation risk persists, could prove trying for some.
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