The insurance-linked securities (ILS) market continues to evolve in the wake of the major catastrophe losses of recent years and one of the most important and ongoing developments is the quest to front cedents as efficiently as possible, A.M. Best explains in a new report.
The rating agency highlights challenges that have emerged after the significant catastrophe losses that flowed through reinsurance and retrocession markets and highlighted ILS funds exposure to such major events.
While issues over collateral retention by cedents, buffer loss tables and trapped collateral remain in focus, the ILS market and collateralised reinsurance providers continue to work to evolve the business model and a key area of attention is how investors and funds can front cedents in the most efficient manner possible.
“In the ILS market, the extreme catastrophe losses over the past few years have highlighted the fact that sometimes what’s good for cedants is not always good for investors, and vice-versa. Yet, cedants and investors have to find a mutually beneficial meeting ground to coexist,” A.M. Best states.
It boils down to finding more efficient ways to operate at the touchpoints between ILS collateral and cedents, be that through ILS funds, direct from investors, or from other collateralised reinsurance vehicles.
How capital and risk connect is the key to the ILS market and the more efficiently that can be made to happen the better for both sides, investors and cedents.
As the ILS market has expanded it has also, in many quarters, been striving to get closer to the sources of risk that are available in the insurance and reinsurance market.
This is achieved through business models, partnerships and collaboration, as well as through making best use of the different routes to risk, or the plumbing of the insurance and reinsurance market.
Fronting arrangements are one area that the ILS market has put in significant work in recent years, developing relationships with large global reinsurers, establishing or working with Lloyd’s syndicates, and even setting up their own dedicated rated carriers.
It’s all about facilitating more efficient access to risk, as well as better outcomes for cedents.
But fronting relationships are never permanent, as was seen with the exit of TMR from that marketplace.
In addition there is the question of risk concentration, with only a handful of players meaningfully offering fronting capacity to the ILS market at this time.
“Of late, ILS investment managers have focused on a new way to access the reinsurance market through fronting reinsurers that are either owned by the ILS funds or have been set up and/or managed by such funds,” Emmanuel Modu, managing director, AM Best Rating Services commented on the subject. “This is a solution some funds have actually implemented and others are contemplating.”
There are a range of business models that can achieve this and A.M. Best explains these in its report, saying that when it analyses a fronting carrier for rating purposes the major considerations relate to the risk it retains and the agencies views on the tail risk it faces from the transformer.
“This tail risk in turn relates to stresses imposed on PMLs associated with the business ceded by the fronter to the transformer and the performance history of the ILS fund managers as well, including how they determine loss reserves and other qualitative issues,” the rating agency said.
This quest to find efficient ways to front cedents is set to continue and perhaps accelerate.
In some quarters, rather than fronting cedents for reinsurance and retrocession transactions, ILS funds and collateralised reinsurance players are establishing structures that give them direct access to pools of primary insurance risk, typically thanks to relationships developed over time with originators and underwriting agencies.
This is perhaps even more efficient as a way to secure certain risk pools and collateralise them and represents an emerging strategy and differentiation from those ILS funds seeking to participate more in reinsurance renewals through their own rated carriers.
There is no right or wrong way to connect capital and risk.
But what is true is that the more efficiently this connection can be made, as well as the lower the expense involved (taking out legacy expense from the chain is key), the better for the cedent and also for the investors, as well as for the ILS fund manager sitting between them.
Fronting relationships and rated carriers are the options currently developing in ILS strategies, while the fully collateralised model also continues to persist.
But whether these are the final business model that helps ILS capital get closer to risk and serve cedents even more effectively remains to be seen.
There is still a need to take costs out of the system and in some cases adding fronting can add complexity and cost. Ways to do this more efficiently are almost certain to emerge in time, as the market for directly connecting capital markets funding with insurance risks continues to develop.
Thanks to technology we’re likely to see other options and routes to access risk emerge over the next few years.