Valuation harmonization could spur substantial ILS growth: Dubinsky, WTW

The insurance-linked securities (ILS) market should harmonize its valuation strategies, as this could encourage greater confidence among end-investors and spur substantial growth in ILS capacity, according to Bill Dubinsky of Willis Towers Watson (WTW).

After the last two years of major catastrophe losses the insurance-linked securities (ILS) market’s valuation models have been severely tested, Dubinsky, Managing Director & Head of ILS at Willis Towers Watson Securities, said in the firms latest quarterly ILS market report.

The experience of the last two years has helped existing ILS investors to get up to speed in some areas, on the use of actuarial models and the like, but valuation remains an area where disparate strategies are used.

Modelling to establish current valuation of ILS and collateralized reinsurance positions is critical for fund managers and their investors, with regular valuations a requirement for reporting purposes.

Dubinsky explained that after the last two year’s of catastrophe losses, “some investors are looking harder at the mechanics,” of the ILS market.

“Data quality and accurate modelling are seen as essential and are under scrutiny, from the initial pricing throughout the life of a transaction. As ever, transparency is crucial, especially in post-loss reporting, which is becoming an important differentiator for cedants. Of course, transparency will still not eliminate reserve volatility, which is simply inherent to a business where every new event differs from its predecessors,” he explained.

On valuation specifically, Dubinsky said that ILS funds, due to the reporting requirements, sometimes have more pressure in this area.

He explained, “Valuation is not really an issue for most non-life reinsurers because they typically do not mark their reinsurance contracts to market in the absence of loss activity.

“In contrast, it is a big issue for ILS funds and end investors because valuation of ILS linked to reinsurance contracts and associated net asset values can have a significant impact on fund entry and exit by end investors as well as management fees and access to leverage.”

Having an accurate view of value is key in offering any type of investment fund, particularly those where transparency and liquidity are supposed to be more readily available, such as UCITS funds, mutual funds and other strategies with features designed to allow investors in and out more easily and frequently.

However, even the ILS and collateralised reinsurance funds need to be making best efforts to provide regular accurate valuations, so they know the price of the units in their fund, and can plan accurately while minimising any surprises in terms of mark-downs and loss creep.

But strategies differ significantly currently and there are issues in both liquid and less liquid investment strategies, Dubinsky says.

“Valuation may differ from investor to investor not only because of differential treatment of reserves and payout patterns but also because of the extent to which illiquid and partially liquid positions are marked to model versus marked to market,” he said.

Going on to say, “If cat bond prices change 20%, do related private investment prices change 20%? If dead cat spreads increase, this strongly implies lower valuations on illiquid positions. Is this taken into account?

“When changes in the liquid market are ignored for the wrong reasons in valuing illiquid instruments, it can lead to potentially misleading valuations, understating volatility and a portfolio mix skewed to illiquidity.”

It’s an important point for investors to bear in mind, as not every ILS manager looks after both cat bond and private ILS (or collateralised reinsurance and retro) portfolios, some are solely focused on one side of the market.

That’s not necessarily a problem of course and there are plenty of expert ILS managers only creating portfolios of one type of ILS asset. But they should be aware of and taking learnings from the broader pricing of reinsurance contract positions, both in ILS and the traditional side of the market as well when marking their books.

While strategies remain disparate, in valuation terms, Dubinsky believes there is room for more consensus on how this important piece of the ILS asset manager job description is performed, with benefits to reap if greater harmony can be found.

Dubinsky said, “Unfortunately, harmonization in valuation practices among ILS funds has occurred at a relatively slow pace. It is as if two automakers calculated the miles per gallon figures on new car stickers using totally different testing approaches: car buyers would complain and the method would change.”

But he added that, “If harmonization in valuation speeds up, it may spur substantial growth in ILS capacity – as end investors would likely gain further confidence in evaluating potential managers and making new allocations to the asset class.”

At this point in the ILS market’s evolution, greater discipline is without a doubt being seen, in terms of practices, as investment managers put their learnings from the last two year’s to work.

Whether harmony could ever be found, in how ILS assets are valued, remains to be seen though.

There’s also an argument to say that a valuation strategy is also a potential source of alpha, as an ILS fund could outperform if it had the best valuation processes in place.

But overall, a more level playing field and greater transparency in how ILS positions are valued is key. ILS managers do need to become better at communicating these important aspects of their job to investors as well.

All of which could definitely have the effect Dubinsky suggests, of driving more capital inflows to ILS fund managers.

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