SBAI highlights need for strong governance in ILS side-pocketing

The Standards Board for Alternative Investments (SBAI) has published a new document that discusses the practice of side-pocketing within the insurance-linked securities (ILS) industry and explains the need for strong governance, transparency and robust disclosure when it comes to reserving for potential losses.

The practice of side-pocketing is broadly used in insurance-linked securities (ILS) fund management, as a way to segregate potentially loss impacted or distressed assets from the rest of a fund portfolio.

This is done to protect new investors from exposure to prior loss events, to reserve for events where loss development is expected and could be protracted, and to effectively manage exposures for investors in the funds in the most equitable way possible.

When losses threaten reinsurance or retrocession positions that ILS funds have invested in, the fund managers may choose to side pocket the potentially exposed assets, so as to protect their investors against any worsening of the position and to segregate the affected assets, so investors can also continue to enter their ILS funds without picking up any exposure to prior loss events.

But, given the long development time needed for some catastrophe events, it can take years for reinsurance loss payments to manifest and be fully made, meaning that a distressed reinsurance position can remain a drag on ILS fund performance.

It’s a practice that is needed, but that is operationally used in a range of ways, resulting in sometimes disparate reporting and valuations, which can reduce transparency for investors.

The SBAI’s new publication provides guidance on the side-pocketing methods that can be used for ILS fund strategies, explains the need for robust governance arrangements, how fees can continue to be charged appropriately, and also provides detailed questions that investors can ask their ILS fund managers during their due diligence of different strategies.

The use of side-pockets within the ILS market has come under increased scrutiny after the heavy loss years of 2017 and 2018, as well as due to the pandemic and potential losses from it.

The industry continues to have a number of billion dollars of trapped capital, that is largely held in side-pockets and exposed to prior period losses and COVID-19.

However, the amount of trapped collateral in the ILS market has certainly reduced since it was between $10 billion and $15 billion around 2019, as ILS fund managers have recovered a significant proportion, or realised reinsurance losses against it.

Commenting on the new SBAI publication, Michael Hamer, Senior Analyst at Albourne Partners (Bermuda) Limited said, “While the use of side- pockets within ILS funds is typically an investor friendly practice, this SBAI Toolbox memo provides a very useful framework for considering the appropriate alignment of interests between the various groups of investors and asset managers as well as a toolkit for ensuring robust practices and governance of the side-pocketing process.”

Paul McCabe, Chief Operating Officer at Securis Investment Partners LLP added “Side-pocketing is an essential mechanism and best practice within open-ended ILS funds to help ensure fair treatment to all investors. Given the variation in approaches and importance of transparency and disclosure when operating side-pockets and reporting on fund performance, it is vital for the ILS industry that the side- pocket process is effectively governed to create the right outcome for investors and asset managers. This SBAI Toolbox memo provides effective guidance on how to achieve this goal”.

Lorenzo Volpi, Managing Partner at Leadenhall Capital Partners also said, “Robust and fair business processes are important for the asset management community as a whole and for ILS managers specifically. The SBAI ILS Working Group has collaborated to produce an effective guide for asset managers to review and enhance their side-pocketing processes as well as important questions that allocators to ILS funds should be asking their external asset managers.”

The Side-Pocketing in ILS memo forms part of the SBAI Toolbox, which provides guidance on best practice for alternative asset managers, including a number of ILS specific guidance documents.