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ILS, the Frankenstein’s monster in the room, or the future?


Weston Hicks, the President of re/insurer Alleghany, has likened the world of efficient alternative reinsurance capital to Frankenstein’s monster, describing the market as untested against the “big one” and problematic because of potential incentive misalignments.

In the company’s annual letter to its stockholders, which details its financial performance in 2016, Alleghany President, Hicks, discussed the presence of alternative reinsurance capital as it continues to take an increasing share of the global reinsurance market.

Hicks states that while alternative, or insurance-linked securities (ILS) structures and vehicles have been highly successful to date, underlined by persistent growth during times of broader re/insurance market challenges, “these new risk transfer vehicles have not been tested by the “big one.””

Prompting Hicks to question whether investors in the space will “re-up” after a substantial loss event that results in the removal of a significant volume of capital, or rather, “have the models created a monster?”

Specifically, questions Hicks, “Are the alternative reinsurance markets today’s monsters performing a bad version of a classic?”

A reference to the 1974 film Young Frankenstein, which sees the monster’s creator attempt to assure and calm scared, and concerned citizens by performing Puttin’ On The Ritz alongside the monster which, as you’d expect, fails miserably.

But unlike the performance of Dr. Frankenstein and his monster the world of alternative reinsurance capital continues to perform well, and even outperform comparable alternative asset classes, despite testing times for the broader insurance and reinsurance markets, also underlined by it’s strong historical performance during the 2008 U.S. financial crisis.

Diversification and low correlation have been and continue to be key drivers for investors when allocating to the space, and the benefits an ILS investment brings to a portfolio really came to fruition during this time, while other alternatives were faltering.

Epitomised by the collapse of Lehman Brothers, the 2008 U.S. financial crisis saw the majority of financial markets stumble and investors struggle to achieve the kind of returns they required and had grown accustomed to.

However, owing to its large focus on catastrophe risk, which clearly isn’t impacted by financial market turmoil as the collapse of an investment bank has no correlation to hurricane activity, for example, ILS performed well during the crisis and institutional investors really started to recognise the diversification and low correlation benefits of their ILS allocation.

Interestingly, speakers at the 2017 Artemis ILS NYC conference held in early February this year also discussed the idea that the market is untested.

Drawing on the performance of ILS during the 2008 financial crisis and the fact that some ILS funds saw their assets under management (AuM) grow substantially after events like hurricanes Katrina, Rita and Wilma, despite the events having loaded large losses for the same fund managers, the ILS experts stressed that the market has paid claims on all formats, and being untested, put simply, just isn’t true and hasn’t been for some years now.

Hicks also questioned the permanence of the ILS capital and investor base following a large event, and while it’s likely some will exit the space after a large loss event, as would be expected in any asset class, the general view within the ILS world is that there’s an abundance of capacity waiting to enter the space at the first sign of opportunity.

John Seo, Co-Founder and Managing Principal at Fermat Capital Management, LLC, highlighted this point during the Artemis ILS NYC event. “For every dollar of money that you see in the market right now, I think there is roughly 10 dollars on the sidelines waiting to come in if the market hardens,” said Seo.

Furthermore, it’s been noted by numerous industry experts and leaders that the abundance of both traditional and alternative capital in, and outside the space, suggests a flattening of the reinsurance market cycle moving forward, and will likely dampen any post-event price surge.

Hicks also said that when a major loss event does occur, which it undoubtedly will, claims must be settled, and “ceding companies using non-traditional capacity” could hear something along the lines of no, you get nothing.

This again draws on the notion of an untested market and one that has little experience of paying claims, something that was discussed by global rating agency Standard & Poor’s (S&P) last summer.

Specific to the catastrophe bond market, which, after the collateralised reinsurance market is the largest sub-sector of the ILS space, S&P said that cat bond investors are as good at paying claims as traditional reinsurers.

“We have explored the claims payment history of cat bonds; in our view, the quality of the collateral and the pre-defined loss calculation offers protection buyers comfort that cat bond issuers are willing and able to pay claims. The timeliness of payments is similar to that of payments by traditional reinsurers,” explained S&P, covered at the time by Artemis.

S&P also said; “The catastrophe bond market has grown rapidly over the past 20 years, and has withstood some of the worst catastrophe loss years on record, including 2004, 2005, and 2011.”

As ILS capacity continues to deepen its relationship with global insurance and reinsurance markets and access a broader set of exposures in new geographies, its potential to experience frequency losses is increasing also as we detailed here recently.

While this clearly results in higher losses for ILS funds, it also shows how successful the marketplace is at paying claims as they become more frequent due to where the capital is deployed in the risk transfer tower, and reflects investment manager and investor maturity and sophistication.

“Some new business models that separate the underwriting decision from the capital provider/risk bearer are, in our view, problematic because of a misalignment of incentives,” continued Hicks.

Giving an underwriter the pen without an alignment of interest is Hicks issue here, something which he highlights has resulted in issues across reinsurance for years.

“To the extent unaffiliated capital is used to assume (re)insurance risks, it is best done side-by-side with true risk takers who have skin in the game,” he continues.

Of course ILS fund managers are aligned with their investors best interests, as if they don’t perform for their investors they will not get paid and will not hold onto their assets for very long. Many would suggest that this alignment is in fact tighter than a traditional re/insurers alignment with its shareholders.

On the client side, ILS funds need to deploy capital into business which meets their return requirements, with the right risk profile and terms to deliver their promises to investors without taking on undue risk.

That means they are incentivised to provide products that work for their cedent clients, otherwise clients wouldn’t want them, while remaining aligned with investors too.

Are traditional re/insurers so aligned on both sides of their business, possibly. However the large corporate world is much further removed from its real stakeholders (shareholders) than the average ILS manager is from its investors (who are often on the end of a phone).

Hicks notes that in his letter he is undoubtedly “talking our own book,” saying that the traditional reinsurance business model or partnering with what he calls “true risk takers” has a number of advantages.

He says; “Firstly, executives of a reinsurance company that receive their compensation from the underwriting results they produce on a long-term basis are more likely to consider what can go wrong and are also more likely to be cognizant of extreme risks than underwriters that are being compensated based on volumes or assets under management with a “carry” measured on an annual basis.

“Second, when large complex losses do occur, a reinsurance partner is able to “trade through” with the ceding company as complex claims are settled, sometimes over multiple years.”

History has not shown that reinsurance company executives are aligned through their compensation structures, over long or short-term basis’. There are plenty of examples of less than disciplined underwriting, exposure accumulations, outsized losses and other issues that suggest re/insurers no more “consider what can go wrong” than an ILS fund underwriter does.

And on the ability to trade through the bad times, a certain well-known ILS fund manager that had almost half its assets drawn down to pay losses after a series of catastrophes in the mid-noughties, came out of that period with even more capacity at its disposal and offered continuity to its client base.

This issue of continuity or trading through the bad times, when difficult losses occur, is also not guaranteed at reinsurers or insurers and there are examples of companies disappearing off the map after major, complex events.

Hicks arguments are the usual set, which yes can happen or be seen, but on both traditional and alternative sides of the market. There is no evidence to suggest these issues crop up more frequently on one side or the other, at this time.

“Technology has allowed the industry to separate the risk-bearing capital provider from the underwriter who decides how much risk to take,” he continues.

The traditional reinsurance model keeps the risk-bearing capital provider and underwriter together, Hicks suggests.

“Call us quaint and old-fashioned, but we like the alignment inherent in the traditional insurance and reinsurance company structure,” he writes.

And here comes the pitch.

“To the extent investors allocate assets to insurance risk, we believe they should make sure they are partnered with a true risk taker that is, as they say at TransRe, battle-tested. While the alternative model is changing the playing field near-term, as long-term investors we believe TransRe’s commitment, discipline and proven approach will win out in the end,” he closes that section of his shareholder letter.

TransRe and Alleghany through the reinsurer are investors in ILS fund manager Pillar Capital, with a stake in the managing company and capital in the Pillar funds. Pillar has some access to risks via the TransRe platform as a result, we assume.

TransRe also has a significant amount of third-party assets under management through its Pangaea collateralised reinsurance sidecars, managed by TransRe Capital Partners, and also leverages third-party capital for retrocession as well.

So is Hicks talking down the alternative capital model just to try to talk up the way Alleghany has approached it? Which is really just promoting traditional over alternative without considering any of the issues he has raised as potentially applicable to his businesses model as well.

When alignments of interest are so clearly part of his concern, Hicks could perhaps mention that alignment is no clearer when a traditional company has multiple pools of capital that it can allocate risk to.

Questions have always been asked of the potential for a traditional re/insurer to be incentivised to underwrite poorer quality risks on other people’s capital, while cherry picking the best for its own. In a fair critique of alternative capital and ILS that should really be mentioned.

There are always alignment questions, on every side of every industry, and reinsurance and ILS are no different. These questions are overcome through transparency, evidence of discipline and diligence, track records, investor and cedent recommendations, as well as leading by example.

Traditional reinsurers can leverage third-party capital to enhance their business model, lay off risk, earn fees by leveraging their expertise and helping investors to access the returns of pure insurance risks.

ILS fund managers do exactly the same, perhaps with closer alignment to their capital providers than large corporates can ever have with anyone other than their largest shareholders.

Of course TransRe and other reinsurers prove their alignment with third-party investors in the same way an ILS manager does, track record, relationships, transparency, discipline and diligence. It’s really no different.

The ILS market continues to demonstrate that it is aligned with its investors and with its growing range of cedents, just as re/insurers have to with shareholders when they start-up and with third-party capital as they increasingly tap into it.

ILS is no monster. It’s a business model that differs, but has everything (increasingly so) in common with reinsurers.

In time the traditional market will move on, leaving these critiques behind. But before time we reach that stage in the cycle we’d predict that alternative capital is playing an even larger role within Alleghany’s business, and that the company has itself continued to welcome the monster in with open arms.

ILS isn’t the monster in the room, it’s the future of many re/insurance business models.

Register today for ILS Asia 2023, our next insurance-linked securities (ILS) market conference. Held in Singapore, July 13th, 2023.

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