New collateral solutions

In the wake of the catastrophes of 2017 and 2018, the ILS sector was presented with a new challenge – that of unprecedented levels of trapped capital.

As cedants elected to hold onto collateral as losses mounted, a large proportion of ILS capacity became simply no longer available.

As much as $20bn – or 20 percent of the ILS market – was tied up at the January 2019 renewals, JLT Re estimated, while Guy Carpenter calculated around 15 percent of third-party capital still remained trapped throughout last year.

The capital lock-up has had implications for the ILS sector and the reinsurance market at large. Deals have not been renewed, the drop in ILS capacity has contributed to reinsurance rate rises, and trapped capital has been a drag on investor returns.

But this new market stress has also led to innovation – new structures and relationships are emerging as old solutions are revamped in a bid to avoid such high levels of collateral lock-up if a series of events similar to those in 2017-2018 were to occur again.

In just one example, Markel recently offered investors in Nephila (which it bought in 2018) liquidity for their trapped capital investments, making hundreds of millions of dollars of capacity available.

Markel will offer investors liquidity at a material discount to their marked net asset value, only at specified trade takes and subject to capacity constraints, a regulatory filing notes.

“It's something we couldn't have done as a private firm and it's something investors have found helpful in navigating the side-pocket aspects of this asset class," says Nephila managing director Frank Majors.

The firm explored many options to address the trapped capital conundrum but felt that other solutions would be cumbersome.

"We can offer [investors] a better deal than external providers," Majors adds.

Not all companies have the chequebook of a reinsurer behind them to pay back investors, but another solution available to some ILS managers to address the problem is a move to rated paper.

A number of ILS managers have already taken this step, with ILS Capital Management becoming the latest firm to get a rating – in this instance from Kroll Bond Rating Agency – for its Bermuda reinsurer Prospero Re, which writes collateralised business for the firm's 1609 Fund.

With its rating, the vehicle is now able to collateralise its cover up to the 1-in-500-year risk level instead of to the full limit it writes, while remaining investor funds will be used to support tail risk taken by Prospero to slightly more than a 1-in-1,000-year level.

ILS Capital has said it expects to move 100 percent of its business to a rated model in the next three years.

"It's a sign of the times," managing partner Tom Libassi says, adding that trapped capital was the biggest issue currently facing the collateralised ILS market.

Prospero Re is the fourth ILS-backed reinsurer to gain a rating, after Credit Suisse ILS set up two vehicles – Humboldt Re and Kelvin Re – and LGT ILS Partners obtained a rating for its Bermuda reinsurer Lumen Re in 2017.

LGT ILS Partners now transacts 70 percent of its reinsurance book on a rated basis through the A- rated platform.

Lumen Re’s portfolio covers an estimated $3bn in reinsurance capacity backed by the vehicle’s equity and collateral from the LGT ILS funds.

Credit Suisse’s Kelvin Re was the first rated vehicle to be set up by an ILS team when it launched in 2014, with backing from the Abu Dhabi Investment Council. It takes a similar investment approach to a hedge fund reinsurer, with 50 percent of its investment portfolio allocated to blue-chip hedge funds.

Humboldt Re has a more traditional investment portfolio that focuses mainly on highly liquid, fixed income paper, which enables it to run a higher underwriting leverage ratio than Kelvin Re.

But both write similar risks, focusing on property catastrophe with some additional exposure to short-tail specialty lines.

The shift to rated platforms by ILS managers is likely to release large amounts of trapped capital as the rated entities take over cover.

LGT ILS Partners portfolio manager and partner Michael Stahel said the approach with Lumen Re mitigated the challenge of dealing with trapped capital for both cedants and investors alike.

LGT often encountered cedants that wanted access to capital market capacity but preferred a rated reinsurer to ease the transaction process as they deemed the operational tasks around managing collateral positions to be too cumbersome. Insurers which do not wish to manage the collateral process face Lumen Re as a rated reinsurer, which cedes the risk on to LGT’s ILS funds.

ILS Capital estimates a rated balance sheet could free up at least half of its own trapped capital from the second year of operating with a rating. At that point, the issue of how much capital to trap becomes an "internal decision", adds managing partner Paul Nealon.

Libassi says the “internalising” of the company’s fronting should enable the firm to cut costs going to third parties.

Some market participants, however, remain unconvinced rated platforms will fully resolve the trapped capital issue.

While rated paper and fronting solutions solve the problem of tail risk for cedants there will still be cash held back behind rated paper providers, according to Hudson Structured Capital Management (HSCM) Bermuda executive Edouard von Herberstein, speaking at the Sifma Insurance- & Risk-Linked Securities Conference in Miami in March.

This is because ILS managers will still create side pockets within their funds and trap capital to allocate losses to the capital providers on the underlying deals.

This viewpoint was echoed by Willkie Farr lawyer Michael Groll, who at the same conference said while rated paper mechanisms were "not as clumsy" as collateralised buffer loss tables, they still involved holding significant capital behind the scenes.

Jutta Kath, head of transaction management at Schroder Secquaero also notes that while rated vehicles present a solution on the face of the matter, they have material cost implications.

Fronting agencies typically pitch their fees as offset by the impact of leverage they can offer ILS managers – which might apply in a no-loss year but in an active cat year the leverage could potentially boost the impact of losses.

There are also concerns about the possible conflicts of interest some see as inherent in the model of ILS platforms using rated paper from a parent (re)insurer, while others note these vehicles can take years to set up.

In terms of gaining investor support to participate in rated paper, these carriers are "a completely different proposal for investors", von Herberstein adds.

Instead of moving to rated platforms, several market participants argue that the existing buffer tables still widely used in the market can be adjusted to make capital more efficient.

According to sources, in buffer tables for 2020 the percentage of capital to be held at the time of loss has gone down from around 200 percent to the 165-175 percent range.

While the percentage held at the six- to 12-month mark remains at around 130 percent in the updated tables, after 12-24 months the buffer has reduced from 110 percent to 100-110 percent (see table).

“People have acknowledged that losses are unlikely to double,” says a source.

“There are a few black swans where losses have doubled in the past but the modellers and the people who adjust for reserves are not wrong by 100 percent,” the source adds.

Schroder Secquaero’s Kath says she doesn’t see any reason to move away from buffer loss tables and that they can continue work for cedants and investors so long as both parties have a constructive dialogue and behave transparently.

There are buffer loss tables in today’s market that “work perfectly” in her opinion, although she criticises tables which have excessively long trapping periods.

Buffer loss periods in excess of 24 months are excessive as they don’t reflect the short-tail nature of the risk, she adds. “Investors need to be treated fairly.”

Horseshoe Group CEO Andre Perez says investors take issue with the way many cedants “start the clock” on the timeframes stipulated in the buffer loss tables.

While typically for buffer loss tables the timer begins at the date of loss occurrence, there have been some instances of confusion over whether it should start at the expiry date of the contract or at the date when the buffer computation is being done.

Perez says that the latter is more appropriate as the computation often takes place several weeks after the expiry date.

But Willkie Farr partner Joe Ferraro says that some cedants prefer to begin the computation at the end of the year as opposed to immediately after the loss occurs.

“That’s when they are able to sit down and look at events in the round in the annual reserving process,” he says.

“There has been some investor push to have buffer loss tables start at time of loss. That has to be weighed against the complication of having to have different buffer losses concurrently,” he adds.

To deter cedants breaching these agreements and not releasing capital as agreed, some ILS investors are now pushing for punitive measures, such as a penalty clause.

Buffer loss tables are “still very much under discussion at the moment”, according to Ricky Spitzer, a partner at Mayer Brown.

“We won’t know what, if anything, will change until later this year when companies are looking to renew their transactions that incept on 1 January,” he says.

Some market participants have speculated over whether a legacy market might develop to provide an exit for trapped capital-lumbered investors.

However, as with rated platforms and fronting carries, this option comes at a cost.

The terms of such a solution would probably be quite poor and investors would be better off hanging on to their investment unless they needed liquidity, one source said.

Legacy carriers typically focus on long-tail lines and may not be the best home for relatively short-tail catastrophe loss reserves, says Perez.

The parent company of one ILS manager was prepared to offer a legacy solution but a more established market has failed to emerge, according to sources.

In another twist in the trapped capital saga, the urgent need to come up with better solutions has forced cedants and investors to build greater trust with one another in the name of making capital more efficient.

“It’s ultimately a relationship business”, says Perez, adding that some cedants are very reasonable and sometimes release capital before they are required to do so when circumstances are permitting.

Libassi stresses that it’s not a matter of investors not wanting to pay claims, but rather that they need an arrangement which doesn’t excessively restrict their ability to deploy capital in other ILS investments.

Although Kath says that investors must in turn be understanding of cedants’ needs and top up collateral if necessary, so long as this need is substantiated by frequently updated loss figures.

Ferraro says he has noticed the close type of relationships seen much more in the traditional market start to play out in the ILS space which is ultimately resulting in less capital getting locked up.

“The investors, who are regular investors year in, year out… are engaged in direct dialogue with underwriters and in negotiating a relationship-based, partnership-based approach will allow for the buffer that is ultimately decided upon to be more efficient,” he says.

“It’s in no one’s best interests to have money sitting where there is no reasonable prospect of that money ever having to be used.”

This article was first published in the Spring 2020 issue of Insider Quarterly