Tag Archives: retrocession

Headwinds Facing the ILS Market

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.

The Need to Automate Reinsurance Programs

“Do you know where your children are?” That was a popular catchphrase in a TV public service announcement.

Do you know where your reinsurance program is? Many senior executives at insurers can’t say for sure.

Many insurers find it a struggle to document their ceded reinsurance program (the risk they have transferred to a reinsurer) in a way that’s acceptable to regulators—and senior management—because they have not automated management of ceded reinsurance policies, data and claims. According to a recent survey, only 14% of primary carriers have a reinsurance system. Most insurers still use spreadsheets or other manual methods to keep track of their reinsurance contracts and claims.

The NAIC Risk Management and Own Risk and Solvency Assessment Model Act (RMORSA) became effective in January 2015, and many states have adopted this model legislation. RMORSA requires insurers to have a systematic way of identifying, assessing and managing risk, and everything related to reinsurance is certainly part of it. Under it, insurers are required to submit an annual summary report to their primary regulator. A key part of complying with RMORSA, and other regulations, will be documenting reinsurance coverage in detail.

It is possible to comply with RMORSA without a true reinsurance system. But it’s a difficult, time-consuming process that doesn’t guarantee good results. Using a spreadsheet and other manual methods to track contracts and claims doesn’t give you everything you need in one place for regulatory filings. For instance, an insurer might not being able to identify out-of-compliance policies. This can occur when a reinsurer requires one or more exclusions in the policies it reinsures. If the insurer issues the policies without the exclusions, the policies are out of compliance, and the reinsurer may deny liability when there’s a claim.

But complying isn’t just a bureaucratic exercise. The RMORSA process also helps insurers get a clearer picture of their risks—and what could be more important for a company whose business is managing risk?

Implementing a modern reinsurance management system enables complete automation, controls and audit trails. It will generate Schedule F and statutory reporting at a click of a button. This, in turn, will reduce Schedule F penalties to the bare minimum.

Managing Risk

Regulatory compliance is hardly the only reason to use dedicated software to track ceded reinsurance. Intricate reinsurance contracts and special pool arrangements, numerous policies and arrays of transactions create a massive risk of having unintended exposures. Inability to ensure that each insured risk has the appropriate reinsurance program associated with it is a recipe for disaster.

An insurer must track and integrate many reinsurance processes. They include cession treaties and facultatives, claims and events, policy management, technical accounting (billing), bordereaux/statements, internal retrocession, assumed and retrocession operations, financial accounting, accounts payable, accounts receivable, regulatory reporting, statistical reports (such as triangulation per line of business, type of contract and region) and business intelligence.

With fragmented solutions such as spreadsheets and manual processes, things often fall between the cracks because there are so many reinsurance-related items to manage. Financial information for trends, profitability analysis and exposures becomes unreliable. Automating processes can reduce the chances of missing something important to almost zero.

Stanching Claims Leakage

One of the biggest problems is claims leakage. How do you know when a reinsurer owes your company money? Answering that question is not as straightforward as it seems, given the complexity of many different types of reinsurance contracts.

For instance, after implementing a reinsurance solution, a European insurer detected more than $1 million of overlooked claims. (You can’t file a claim if you don’t know you have one.) It contacted its reinsurer, which paid promptly.

The situation for insurers that don’t automate will only get worse. Many of the experienced reinsurance administrators have retired or will be retiring in the next few years, and there are few in the pipeline coming up. With reinsurance becoming ever more complicated, the only feasible answer for insurers is a comprehensive reinsurance system that puts everything in one place. The effort and cost are well worth the benefits in staff productivity, risk reduction, better claims tracking and improved regulatory compliance—to avoid RMORSA remorse and a host of other problems.

Captive Insurance Reinsurance Pools – Where's My Money?

As smaller captive insurance companies proliferate, so do reinsurance pools or exchanges that attempt to deliver sufficient “risk distribution” to satisfy the requirements of the Internal Revenue Service. Without risk distribution, the captive would not be considered an insurance company for tax purposes and would then lose many of its potential tax benefits, including the election for the exclusion of insurance revenues from income under section 831(b) of the Internal Revenue Code.

Previous articles I have written have explored the mechanics of these pools and have questioned whether the majority in fact meet the risk distribution requirements as a matter of law. This article will explore a more basic issue … are the funds being held by these pools secure?

Many captive managers have formed risk distribution mechanisms whereby the captives under management “swap” risk by ceding a portion of each captive's risk to the other captives and accepting a “retrocession” of risks from those other captives. Frequently, this exchange of risk is accomplished by a transfer of 50% or more of a captive's annual premium income to an entity that is affiliated with the captive manager, either as a “fronting” company to the captives or as a reinsurance company.

In either event, half of the funds paid by the insured to the captive are held for a year or more by this entity. Once losses are settled for the year in question, the balance, if any, is remitted to the captive. In the meantime, of course, if the captive has renewed its insurance policy to the insured, another annual premium has been received by the reinsurance entity and handled in the same manner.

The potential for abuse is immense. Cash is fungible. Whose money was remitted to the captive? The half that was held from last year or half of the latest premium received? This could create a classic case of a “Ponzi” scheme, where the money held from last year is spent and new money is used to cover the obligations from the previous year. The scheme collapses, of course, if there is a net drop in new captive formations for that captive manager.

These fronting companies or reinsurance companies are often domiciled offshore where annual audited statements may not be required and where litigation over mishandled funds would be difficult for the captive owner. Not all risk distribution mechanisms involve the retention of client funds; unfortunately, however, most of them do.

This article does not suggest that any captive manager has in fact mishandled client funds as described. But it is important to recognize the temptation and ask what, if anything, is being done to be sure that the temptation is never tested. A captive manager with 100 captives under management — each with $1,000,000 in annual premium — will have $50,000,000 or more of “float” to tempt him.

At a minimum, captive owners should require an accounting of retained funds by an independent CPA firm. Ideally, the captive owner should require that retained funds be held in a separate trust account by an independent trustee. But neither of these practices appears common in the captive insurance industry. In some cases, captive mangers have returned the “withheld” funds early, easing the fear of loss of the funds, but potentially making a mockery of the risk distribution mechanism itself.

What is the role, if any, of the captive insurance regulator? Captive legislation is not consistent when it comes to reinsurance pools. A review of the legislation of 14 of the most active captive domiciles reveals that 8 of them have no provision in their statutes to monitor or limit the activities of reinsurance pools (other than actual reinsurance companies licensed in their own domicile). The other 6 have specific language as follows:

The Commissioner may require any other documents, financial information, or other evidence that the pool, exchange or association will be able to provide adequate security for its financial obligations. The Commissioner may deny authorization or impose any limitations on the activities of a reinsurance pool, exchange, or association that, in the Commissioner's judgment, is necessary and proper to provide adequate security for the ceding captive insurer or segregated account and for the protection and consequent benefit of the public at large.

The domiciles break down as follows:

Specific language: Vermont, Missouri, District of Columbia, Kentucky, Montana and Tennessee.

No language: Delaware, Utah, South Carolina, Nevada, Arizona, Hawaii, Alabama and New Jersey.

It is interesting that the majority of small captives that use these reinsurance pools are domiciled in the 8 states that give the regulator no direct statutory authority to address the security of retained client funds. Of course, the regulators do have broad authority to question the overall efficacy of a captive's business plan. This review arguably could address concerns about the security of the captive's funds in the hands of third parties, particularly in the early years of a captive's life. But do they?

This author polled a number (but not all) of the regulators in these 14 states and got few responses from the 8 states without the specific language referenced above. Those few responses indicated that their view is that the relationship between the captive and the fronting company or reinsurer was a matter of private contract not subject to their regulation (other than determining that the reinsurance itself was real and met industry standards).

As the number of captives, captive managers and risk distribution pools continues to grow rapidly, the opportunity for a scandal in the captive industry also grows. The industry would not fare well if such a scandal made the front page of the Wall Street Journal. Captive owners should be aware of this risk and take action accordingly. And captive regulators should become more alert to possible abuses in this area and take action consistent with the powers available to them under their respective statutes.