Investors appreciate contract certainty, fear unanticipated sidecar losses: Willis Re

Insurance-linked securities (ILS) investors may look more favourably on the catastrophe bond in future, as its relative contract certainty compared to some collateralised reinsurance and retrocession structures means they are less likely to be impacted by unexpected losses from the Covid-19 pandemic.

Catastrophe bonds, given their largely named peril approach to catastrophe reinsurance and retro coverage, seem more remote from the effects of losses caused by the coronavirus outbreak.

Aside from the relative uncertainty of the “other perils” category in a handful of catastrophe bond transactions covered peril definitions, largely the cat bond markets exposure is in life and mortality related lines of reinsurance coverage, as you would likely expect in a health pandemic.

As we’ve explained before though, a lack of exclusions, or poorly worded contract language, could result in some Covid-19 claims falling to reinsurance and ILS markets in certain collateralised positions.

In addition, quota share sidecar vehicles and private quota share arrangements could see more of a hit from the Covid-19 claims burden, given they tend to follow the fortunes of a re/insurer and can often include a broader range of property coverage than catastrophe alone.

Reinsurance broker Willis Re highlighted the importance of this contract certainty in a recent report and opined that this could actually end up driving more ILS investors towards catastrophe bonds at this time and potentially create a dent in investor demand for certain sidecars.

Of course, there are more reasons to like cat bonds after the initial volatility created by the pandemic than just their contract certainty.

The catastrophe bond and broader ILS asset class has performed admirably once again, during a period of global financial market uncertainty.

“The current financial crisis is re- emphasising the value of portfolio diversification through ILS. As expected by theory and experience ILS outperformed many other portfolio investments on a relative basis at a time of broader market turmoil,” Willis Re explained.

Adding that, “Consequently, end investors are likely to view the behaviour of the cat bond market positively after the COVID-19 crisis. This may result in potential increased allocation to the space in the future.”

But, perhaps more important for the direction of longer-term inflows to the ILS market and reinsurance linked assets in general, the fact it is easier for fund managers to quickly identify potential exposures related to cat bonds, than it is to some other private ILS assets, could also be a future driver of investor appetite.

“Some end investors view the relative contract certainty in the cat bond market more favourably than in the past,” Willis Re believes.

While, “In contrast, the impact of COVID-19-caused BI on other ILS products is far less clear.”

Raising the very real concern and meaning, “Investors fear this lack of clarity may result in both unanticipated losses and/or substantial trapped capital for other ILS products.”

Willis Re highlights the sidecar as one ILS structure where investors fear surprises from Covid-19 related business interruption could emerge.

“Whether the COVID-19-related BI losses will impact the sidecar market or not will meaningfully impact investors’ long- term confidence in the product — and there are real worries on the part of investors of this possibility,” the brokers team explained.

Willis Re also highlighted that investors allocation decisions will likely remain driven by relative performance though, “Ultimately, investors will decide on their allocation to sidecars for next year based on the relative performance of their own investments against other investment opportunities (within or outside the ILS space) at the time of renewal.”

With so much hanging on wordings and contract certainty, when it comes to the eventual size of any losses that flow to reinsurance and ILS players, terms and conditions are sure to be a strong focus at the renewals.

With investors appreciating contract certainty more than ever now, it seems some of the undoing of T&C’s that we’ve seen over the last decade may begin to get reversed to a degree, or at least loopholes closed and gaps narrowed.

Willis Re concurs, “Rather than, or in complement to, a change in capacity, investors may be pushing for tighter terms and conditions, a trend that started at the end of 2018 and that was confirmed at the 1 January 2020 renewal already.”

As we explained the other day, some of the specialist ILS fund managers have already begun marking their books, to reflect the risk of potential exposure and perhaps even some losses caused by the Covid-19 pandemic to certain positions in their portfolios.

Sidecar investors are not all as sophisticated as the dedicated ILS fund managers and so won’t perhaps have the visibility of any potential exposure until losses are reported to them by the sponsors of such vehicles.

Which, alongside the potential for unanticipated losses, could mean some of the larger backers of re/insurer sponsored sidecars look more seriously at deploying to some of the dedicated ILS funds again in future.

Also read:

– ILS funds marking some positions for potential Covid-19 exposure.

– Lack of exclusions, poor wordings the Covid-19 BI threats to reinsurers & ILS.

– Massive Covid-19 losses likely, but forced claims could bankrupt: Industry CEO’s.

– Hiscox ILS funds not exposed to UK SME business interruption claims.

– ILS funds face inflow challenges while Covid-19 uncertainty remains.