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February 7, 2019

Headwinds Facing the ILS Market

Summary:

Insurance-linked securities provide an important source of capital for insurers and reinsurers, but their risks are being highlighted.

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Hurricane Andrew’s devastation and lasting financial impact created a need for an alternate means to access capital and transfer risk. Enter the Bermuda market, and, on its heels, the insurance-linked securities (ILS) market.

The latter has been growing steadily ever since the mid-1990s. Fast forward. and some traditional reinsurers now offer ILS fund management. Other reinsurers have purchased prominent ILS fund managers, as was most evident with the well-publicized Nephila acquisition by global re/insurance giant Markel. This recent mainstreaming had brought about all sorts of acknowledgment.

However, while everyone was patting each other on the back, various catastrophes were occurring on a global scale. From earthquakes, floods and typhoons in Asia to hurricanes and fires in North America, the industry incurred increasing losses in 2018. Coupled with the 2017 loss creep, these losses have affected several ILS vehicles, and investors/fund managers are rethinking their respective capital allocation strategies in the coming renewal season.

ILS plays an important role in providing efficient capital to insurers and reinsurers (through retrocession) that sponsor the deals, but it is not without risk. Recent developments in the marketplace have the collateralized funds space facing headwinds. For these important investment vehicles to continue as beneficial components of ceded reinsurance programs or investor portfolios, some things need to change.

Perhaps the greatest contribution from ILS has been its ability to smooth pricing volatility in the regular reinsurance underwriting cycle. Every time there has been a large storm, or series of storms, reinsurers respond by raising prices in a phenomenon known as “payback.” This cycle went on for many years until the recent ILS “coming of age.” With an abundance of capital, reinsurers are pressured to keep their rates down to compete for shares of a given deal. Reinsurers are also able to take advantage of this downward pressure in pricing with their own reinsurance known as retrocession.

Along with helping insurers/reinsurers access capital for additional capacity, ILS are a means for institutional investors to diversify their portfolios to non-correlated risk. What this means is that rather than their funds being tied to financial markets, where they’re subject to things like credit risk, the funds are tied to triggers from catastrophic natural disaster events. In addition to this diversification, the returns also make ILS an attractive investment to the sophisticated institutional investor. In the absence of considerable aggregate loss totals, these transactions are a “win win” for all parties involved.

Followers of reinsurance industry news in 2018 know there’s no shortage of praise directed toward the ILS space. But a shift in attitudes occurred very recently, months or even weeks ago.

The industry was so impressed with the resilience of the ILS market following the 2017 HIM losses (Harvey, Irma and Maria) and the “reload” of capital that followed. However, this “reload” of capital occurred prior to realizing the additional effects of the 2017 loss creep from the HIM storms. Loss creep occurs when the final loss amounts from an event aren’t known and the reserves must be increased due to changes in projections.

Along with the 2017 loss creep, 2018 shaped up to be another year of catastrophic losses. The California wildfires, Typhoons Jebi and Trami in Japan and Hurricanes Florence and Michael in the southeastern U.S. all added to the problem seen in collateralized reinsurance deals.

In a collateralized reinsurance transaction, collateral is put up by investors to cover the full limit of the reinsurance contract. As a result of the catastrophes piling up, much of the collateral on the deals has become “trapped.” While the final loss number is being determined, the trapped funds cannot be moved or re-allocated into new deals. We’re seeing that this has led to some fund managers having difficulty renewing core components of their portfolios. This could lead to reinsurers being more aggressive to take back their market share with traditional capital. Perhaps this is just a short-term correction, but one thing is for sure: The trapped collateral issue needs to be solved sooner rather than later.

See also: Fixing the Economics of Securities Defense

These recent changes in the ILS marketplace have only affected a few funds and strategies. According to market intelligence sources, most are renewing as planned. However, the changes highlight the potential for disaster down the road if nothing is done to correct these issues.

In my mind, there is an excellent opportunity for sponsoring insurers and reinsurers to collaborate with the investor base and fund managers. Collaboration could lead to outcomes that better provide sponsoring organizations with the efficient capital/collateral that they’ve come to rely on while simultaneously providing investors with greater flexibility in the deployment of their capital. Insurers, reinsurers and institutional investors have demonstrated their needs for ILS, and it’s up to all parties involved to continually improve the space.

Insurance-linked securities are the present and future of risk transfer, but recently their vulnerabilities are being exposed. The negative effects of trapped collateral threaten to disrupt more funds if enough capital is tied up.

Thankfully, ILS experts are reportedly working diligently to solve this problem. ILS provides sponsoring insurers and reinsurers an efficient source of capital while providing diversification for institutional investors. I’m inclined to believe that, for these reasons, ILS arrangements are here to stay in some way, shape or form.

Throughout this piece, I’ve put myself at the risk of oversimplifying a very complex subject. There are different types of ILS vehicles, fund strategies and investor types currently in existence. In fact, you’ll notice that I didn’t even touch on the potential impact of rising interest rates; that’s a discussion for another time. My hope is that these thoughts will provide additional dialogue on the headwinds facing the ILS space. These difficult times are a test and an opportunity for improvement that could lead to a more efficient, capital-rich market.

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About the Author

As an innovator spanning decades, E.W. “Ted” Blanch, after joining E.W. Blanch & Co. in 1958, became CEO in 1977 and held the position until 2000. The company was sold in 2001. He then formed Ted Blanch & Associates, a consultancy to the reinsurance industry.

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