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Rise of private ILS creates valuation complexities: Aaron Koch


Increasingly, growth in the ILS sector has come from private transactions that closely resemble traditional reinsurance business, such as collateralised reinsurance, but these contracts and structures can be more difficult to value.

While this trend does present opportunities for insurance-linked securities (ILS) funds it also raises challenges around valuation, according to Aaron Koch, a Director and Consulting Actuary with the ILS Group (P&C Division) at Milliman.

“This expansion of collateralised reinsurance and other private risk-taking structures (such as Lloyd’s syndicates and fund-sponsored reinsurers) enables funds to underwrite a much broader range of risks and access higher returns, but it also poses a set of new challenges,” explains Koch, in a white paper within a recent publication by Clear Path Analysis.

Along with the impressive growth witnessed in the catastrophe bond market in recent years, the rise of collateralised reinsurance has greatly contributed to the global expansion of the ILS sector, which now makes up approximately $70 billion of the reported $427 billion total reinsurance capital-base.

As underlined by Koch, collateralised reinsurance and other private ILS transactions, which include sidecar ventures, cat bond lites, and other insurance or reinsurance-linked assets, enable ILS funds/managers to write a greater portion of diversifying, perhaps previously inaccessible peril regions’ business.

Clearly, this provides ILS funds and the third-party investors that provide much of the capacity with welcomed opportunities to increase efficiency, and ultimately the potential to boost profitability.

However, the continued blurring of the lines between traditional and alternative reinsurance markets, which has resulted in ILS funds holding “portfolios that look increasingly like those of traditional reinsurers,” brings challenges that are more typically borne by the traditional reinsurance marketplace.

Koch explains, “One such challenge is the valuation of these generally illiquid instruments.”

Unlike traditional 144A catastrophe bonds the large majority of private ILS contracts and ventures don’t have a secondary trading element and are far less liquid.

As a result of this Koch explains that for most private ILS transactions there is no suitable “mark-to-market” price that reflects risk seasonality, meaning that funds that wish to value private reinsurance business consistently with mark-to-market instruments (such as 144A catastrophe bonds) need to create a “mark-to-model” valuation approach that incorporates elements such as risk seasonality into the valuation.

While in theory this might sound simple enough, Koch notes that in reality, some private ILS deals have complexities such as covering multiple perils and regions across both property and specialty lines, as seen with traditional reinsurance contracts.

The above, combined with the potential inclusion of un-modelled risks, “requires substantial modelling resources,” says Koch, that perhaps certain ILS investors may lack when compared with traditional reinsurers.

Another consideration that private ILS deals bring to the valuation process is the potential need to accrue incurred-but-not-reported (IBNR) loss reserves, says Koch.

This relates to the fact that many private ILS placements – unlike traditional catastrophe bonds that are usually designed to trigger following only the most severe events – can be triggered by more than just the largest events.

This includes contracts with smaller, local insurers that have the potential to suffer fairly large losses from a single localised catastrophe, placements that are exposed to an aggregation of losses, and quota share private ILS deals, notes Koch. For these deals, the possibility exists that the contract may suffer a loss from an event that is not immediately known to the fund when it occurs.

“As such, funds must consider whether they need to begin systematically accruing loss on their private reinsurance deals as soon as premium is earned and before a known loss even is reported,” explains Koch.

Absent the use of IBNR with private ILS contracts, Koch stresses that a “fund risks over-accruing profit in the early part of a contract, only to recognise a greater portion of the loss later on, providing an inconsistent valuation over time.”

Beyond seasonality of risk and the adoption of IBNR, Koch feels that a third challenge with the expansion of private ILS deals is the growing role of “risks-attaching contracts,” which is most common with quota shares.

ILS funds that participate in risks-attaching contracts are accountable for a portion of losses on all policies underwritten by the cedent within a predetermined time frame. As a result, the valuation process becomes more complex, as the investor is accountable for losses after the expiration date of the contract, as long as the loss occurs on a policy underwritten during the contract period.

Clearly, ILS funds and third-party investors are keen to expand their presence and further boost their capabilities within the global re/insurance landscape. But as highlighted by Koch, a shift towards more traditional reinsurance placements alongside the more traditional ILS deals, adds both challenges and opportunities.

“One of the most important new considerations is the additional complexity that private deals bring to the valuation process.

“In the traditional reinsurance market, premium earning and loss reserving practices can represent an important differentiating advantage – or shortcoming – for companies. We are quickly reaching a stage where the same is becoming true for ILS funds, a sign of the continuing development of the alternative capital market,” concludes Koch.

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