Recognising the value of ILS
“Investors expect—and funds and their managers want to provide—more transparency around firm practices, including how valuations are determined.”
Ajay Mehra, HSCM
As interest in ILS increases among institutional investors, the industry is under pressure to provide transparency around topics such as risk management processes and asset valuations, as Ajay Mehra, a partner and chief legal officer at HSCM, tells Bermuda:Re+ILS.
Insurance-linked securities (ILS) have come a long way in a relatively short period of time, with the asset class attracting interest from an increasing number of institutional investors such as pension funds and endowments.
In 2008, when mortgage-backed securities (MBS) were blamed for causing the financial crisis, investor interest in securitisations took what looked like a fatal blow. Since then, however, securitisation has done much to repair its image among regulators and investors alike.
“After 2008 and what happened with MBS, there was a significant lack of confidence around securitisations, and regulators in the US and Europe sought to address those issues,” recalls Ajay Mehra, a partner and chief legal officer at Hudson Structured Capital Management (HSCM).
“It is now 12 years since the 2008 crisis and a lot has happened in this industry. There was a spotlight on the financial services industry and more protections were put in place. There is more risk-based analysis, and more scrutiny.”
This has emboldened investors to return to the MBS market, and to look at other securitised asset classes such as ILS. Lessons have been learned, however, and investors are less willing to put their money into things they do not fully understand. While this is certainly healthy, it is a challenge for an asset class that is more complex, and harder to understand, than your standard bond or share.
“I would argue that most people understand equities fairly well as an asset class,” says Mehra, who started his career at the US Securities and Exchange Commission, first conducting compliance inspections on regulated entities, such as investment funds and advisers, and then ensuring registrant practices and disclosures were consistent with the US federal securities laws, regulations and interpretations.
“ILS is more of a ‘sophomoric’ asset class in terms of its life cycle. Investors typically need more information to understand and feel comfortable with it, including with respect to its underlying risks, illiquidity and judgement around valuations.”
This has translated into investors demanding ever more detailed information about the securities they are investing in. “Fund-offering memoranda used to be shorter documents, but now they tend to run to hundreds of pages with more and more disclosures,” says Mehra.
“Investors expect—and funds and their managers want to provide—more transparency around firm practices, including how valuations are determined, how investments are allocated across clients, investment strategies and risks, and how potential conflicts of interests are addressed.”
While investors are gaining comfort with ILS over time as a result of their experience of investing in them, their thirst for information about these investment opportunities is not letting up.
Mehra says: “Disclosure is likely to keep increasing in line with increasing—and more nuanced—regulation and practices. That will mean offering documents will continue to grow.”
“If one investor has material information related to a fund in which they are invested, then all investors in that fund should have access to it.”
This will mean ILS managers not only providing increasingly more detail about the policy risks underlying ILS, but finding ways to deliver clearer and more pertinent information, he adds.
“Investors will likely demand that ILS funds employ independent, third party actuarial consultants to give them confidence in asset valuations—as we already do,” he predicts.
Investors are justified in having questions around valuations for ILS funds in particular, which typically have significant exposures to large catastrophe events that are often complex and therefore difficult to value. The ultimate insurance-related losses may take some time to reveal themselves, leading to inevitable price uncertainty.
“The valuation required is a single number, but this number is often the summary of a wide range of potential outcomes,” notes the international standards-setting body the Standards Board for Alternative Investments (SBAI).
The valuation problem is about more than just complexity, with legitimate differences in process also leading to different outcomes.
“A manager using a cedant’s reported loss estimate may come up with a different valuation than a manager using a market share approach,” notes SBAI. “Or, a manager may make an adjustment to a cedant’s reported loss estimate resulting in a different valuation than one from a manager that does not.”
The industry is working to give investors greater confidence around things such as asset valuations. The SBAI, of which HSCM is a signatory member, seeks to create common standards across the alternative investments industry. In 2019 it published the SBAI Toolbox memo on the valuation of insurance-linked funds, to increase consistency among funds in their valuation methodologies and advise investors about questions they should ask managers.
SBAI’s recommendations include making arrangements to specifically mitigate any possible conflict of interest between new and existing investors and those looking to redeem; ensuring the valuation function is separated from portfolio management; and disclosing procedures in a valuation policy document.
Different investors tend to have different appetites for levels of detail, notes Mehra.
“Sophisticated institutional investors typically have teams that understand complex ILS-related investments and related operations, while others employ consultants who add value by understanding and analysing information on behalf of their clients,” he says. For fund managers this creates different kinds of challenges.
“We are very cautious about not selectively disclosing material information to certain investors,” says Mehra. “If one investor has material information related to a fund in which they are invested, then all investors in that fund should have access to it.”
He notes that investors who want extremely granular, portfolio-level transparency about a fund’s activities can invest in a fund-of-one, a bespoke fund created for a single investor, which can offer much greater transparency and a more tailored investment strategy. Such a fund can also offer additional controls, such as board seats.
HSCM’s solution has been to offer consistent transparency to all its investors but to seek to limit itself to sophisticated, institutional investors that are more likely to share a similar appetite for transparency and a similar ability to digest the information offered.
“ILS is a complicated asset class requiring, we think, a higher level of understanding,” explains Mehra. He points to the large number of control individuals and actuaries HSCM employs, and the number of models and simulations it considers with each investment, as evidence of the relatively high level of sophistication needed among its investors.
As more investors look at ILS, structurers have been keen to diversify the product by expanding beyond the property cat lines typically used as the underlying in these securities, into new lines of insurance such as cyber.
Mehra believes there are interesting opportunities for cyber and other forms of ILS, but urges caution.
“With nat cat we have hundreds of years of information, allowing us to better understand trends and loss experience,” he notes. “That gives us a frame of reference for analysing such risk.
“Compare that to cyber, which is becoming increasingly prominent, but does not offer the same historical or pertinent data. An ILS fund that invests in cyber has to be aware of the huge distinction between the two in terms of data and relevance.”