Rating agency A.M. Best said that varying pandemic related impacts are to be expected for the insurance-linked securities (ILS) market, with the most concerning likely the fact that collateral could be trapped for years given the significant uncertainty over potential losses.
There have already been a range of impacts seen in the ILS and catastrophe bond market, from the initial sell-off of cat bonds by generalist investors such as multi-asset managers, to the initial marking down of certain positions in portfolios of collateralised reinsurance and retrocession as ILS fund managers try to identify where losses could leak through.
Add to that the fact some catastrophe bonds have been delayed or pulled from being issued in the primary market and the ILS industry has already faced its share of disruption due to the Covid-19 coronavirus pandemic.
But rating agency A.M. Best warns that the most disruptive effect could be the fact the ILS market may see trapped ILS capital for multiple years, given the legal uncertainty surrounding property insurance and reinsurance coverage related business interruption claims from the pandemic.
But in the main, the overall ILS market impact from the Covid-19 is expected to be limited, A.M. Best says, given the ILS market’s coverage offerings are largely focused on named peril events and natural catastrophe reinsurance or retrocessional protection.
The cat bond market and its investor base has felt immediate financial impacts from the pandemic, due to the losses now being paid out by the World Bank’s catastrophe bond, plus the threat posed to certain mortality cat bonds and health insurance-related ILS transactions.
But the broader ILS market, including collateralized reinsurance contracts, sidecar structures or private quota shares and industry loss warranty (ILW) contracts, are expected to see “see varying impacts from the ongoing crisis,” A.M. Best explained.
Hanging over this side of the market are legal actions related to business interruption coverage in the property insurance and reinsurance market, which A.M. Best believes will continue to rise in incidence.
“The impact on the traditional and collateralized reinsurance markets will hinge on how successful these efforts are,” the rating agency explains.
But A.M. Best warns that it, “Expects COVID-19 exposure to result in additional “trapped capital” that likely will be held for multiple years given that the ultimate quantification of covered losses will prove much more challenging.”
The ILS market is now experienced at dealing with trapped collateral and ILS capital due to challenging and developing loss situations.
It also has some experience at dealing with trapped ILS capital that carries an element of litigation risk, as seen with the assignment of benefits driven loss inflation in Florida from hurricane Irma and how that drove elevated levels of collateral trapping and ultimately ILS market losses.
But it does not have experience of trapped ILS capital under such significant uncertainty as we now see with Covid-19, given there is as yet no clear view of where losses could come from, how large they could be, or how long they could take to develop.
A.M Best said, “To the extent reinsurers follow the fortunes of insurers, the business interruption losses will impact the traditional reinsurance market and the collateralized reinsurance market.”
While on quota share arrangements, “The quota share sidecar could see more claims activity, leading to capacity constraints in the retro segment of this market. Overall impact, however, may be limited given the low sublimit for business interruption coverage.”
As we explained before, the significant uncertainty related to the ultimate loss faced by the ILS market from the Covid-19 coronavirus pandemic will make it challenging for new inflows to come to the market without structural work to help accommodate them being undertaken by ILS fund managers.
The threat of trapped ILS capital lasting for some years with no real certainty over whether losses will ultimately be faced, would be a significant drag on some ILS fund returns.
But the legislative actions and lawsuits are set to be the driver of this and at this time this is a developing situation, meaning there is little certainty available to ILS fund managers at all.
Hence those ILS funds taking early actions to reserve for specific contracts where concerns about lack of exclusions are clearest is a prudent move, as too are any steps taken to side-pocket potentially affected ILS assets.
By protecting investors against the potential litigation risk that is developing, ILS fund managers will stand in a much better position when it comes to raising new capital and also segment the potential multi-year drag from the rest of their portfolio returns.