Solving the trapped collateral conundrum
There are several possible solutions to the ongoing problem of trapped capital, the best of which may be the creation of a secondary market for ILS, say Peter Dunlop and Kier James of Walkers Bermuda.
“Rated paper is likely to be the preferred option for those that are particularly concerned by the implications of no clawback.”
Peter Dunlop, Walkers Bermuda
“Bermuda and its nimble and inventive insurance market is the ideal environment for exploring such solutions.”
Kier James, Walkers Bermuda
For many insurance-linked securities (ILS) managers, 2020 has been another challenging year, with the spectre of trapped collateral rearing its ugly head again. Uncertainty caused by the COVID-19 pandemic, combined with a series of more reasonably anticipated smaller events such as hurricanes Zeta and Delta, has eroded the retentions of aggregate covers for a number of the larger insurers.
With the continuing loss creep of 2017 from Hurricane Irma the process of collateral release to investors, or redeployment to following years, by ILS managers has been made extremely difficult. Some investors are withdrawing from the ILS space. Others are sharpening their knives for disputes. Some ILS operations have moved to the evergreen, rated paper model instead.
,With that said, a great deal of remedial action has been taken by many ILS operations to build trust with investors. This has included the provision of even greater transparency to encourage a flight to quality and a further refinement of buffer loss tables in reinsurance contracts, the negotiation of which will have been facilitated by the hardening of the insurance market. However, buffer tables can be only a part of the solution.
The enforcement of those buffer tables can be exceptionally challenging. Investors are not parties to the reinsurance contacts and cannot enforce the buffer terms directly. In turn, ILS vehicles cannot reasonably sue their cedants when those cedants are unable to set accurate reserves because their own insureds can only provide a wide range of COVID-19 loss scenarios. Who knows whether a US state legislature will mandate that COVID-related business interruption claims are covered, despite there being no physical damage?
As a result cedants have taken overly conservative positions on loss estimates to avoid having to return collateral, if and when losses develop further. Irma has reminded us that collateral cannot be clawed back once released. This has given rise to investor frustration and an inability of ILS managers to deploy that capital elsewhere.
It is made worse when cedants leverage their control over investor funds in the trust account to negotiate favourable terms for renewal. ILS managers must therefore walk an invidious line between doing their best to recover investors’ capital while avoiding a souring of relationships with cedants, their sources of business. In view of the structural wrinkles collateralised reinsurance comes with when compared to rated reinsurance, the job of the outwards reinsurance buyer is a perilous one.
This may all potentially have macro effects on the insurance market. Any hardening of the market may be dampened due to capacity being, for all intents and purposes, locked in for years after expiry of the loss period. Ultimately, this reduces the net asset value (NAV) of ILS funds and reduces investors’ returns making it challenging for ILS funds to attract new investors in softer market conditions.
ILS has often responded by side-pocketing these positions to allow NAV to be based on actively traded positions. Unfortunately this does nothing to alleviate the underlying problems associated with trapped collateral.
Understandably, cedants have also become increasingly cautious, with some questioning their reliance on collateralised reinsurance capacity. The concern is that collateralised capacity is transient and that those ILS reinsurers do not have the patience to deal with trapped capital issues.
In turn, investors are dismayed by the end of the 10-year run of fantastic diversified returns. Some do not see it as worthwhile investing in a reinsurance risk transfer product where the cedant has sole use and benefit of the collateral set aside to pay losses. Added to that, there remains a degree of inherent distrust between rated reinsurers and ILS.
This has all led many cedants to demand clawback, and some have arbitrated the issue. Other cedants are insisting that business is written on rated paper instead.
The Bermuda Monetary Authority’s (BMA) release of the Special Purpose Insurer (SPI) Guidance Notes has clarified the position on clawback and other aspects of the collateralised reinsurance product. We await with interest the publication of the Collateralised Insurer Guidance Notes for clarification of whether that intermediate class of Bermuda “collateralised insurer” will offer any more solutions to these problems.
The way forward?
What can be done about the collateral trapping issue? A few approaches appear to have been adopted to alleviate the problem. The first of these is for funds to establish a rated insurance entity.
This gives cedants increased options, which may be particularly valuable for those with constraints imposed by their internal capital model and Bermuda Solvency Capital Requirement. Rated paper is likely to be the preferred option for those that are particularly concerned by the implications of no clawback. The rated model also offers potential advantages to ILS funds. Not only are they able to attract new cedants, and retain existing ones, but it allows differentiation of the product offering with different price points depending on the priorities and concerns of the cedant.
In addition to establishing a rated reinsurance carrier, ILS funds have explored the use of fronting arrangements for their reinsurance vehicles. These have a range of possible advantages. In particular, the cedant obtains rated paper with the reinsurance entity able to achieve a degree of leverage by ceding away tail risk, for what can be an attractive fee for both the reinsurer and the fronting carrier.
The increased use of fronting partners is a well-developed option in Bermuda and the BMA has become increasingly comfortable with that approach. Conversely, large reinsurers have recognised the benefits that can exist for both ILS funds and rated insurers, in particular the fees paid by ILS investors and the ability to cede risk to these investors directly, which has led to some notable acquisitions in the past.
Although the above allow funds to circumvent some of the problems encountered as a result of trapping, they don’t address the problem of being unable to re-utilise collateral in positions that are already trapped.
No doubt ILS funds have explored various exotic options to achieve this but these have yet to be extensively adopted and are currently little known. Perhaps the most obvious solution will be securitisation, the trapped collateral being used as security for bonds issued at discount to face value.
This then provides collateral that can be deployed in other investments to generate additional returns for investors. However, whether counterparties are able to reach terms that are mutually attractive is another issue altogether.
An alternative solution may be a similar concept to Lloyd’s reinsurance to close. Capital providers may see opportunities in taking over positions, where contracts allow, to provide increased liquidity to ILS. We recognise that the same problematic issues arise but perhaps in a hardening market and with a better understanding of claims development after events such as Irma, such opportunities may become increasingly attractive to both parties.
The best solution
The optimum solution would be an exchange, to trade all ILS securities on a liquid, free-flowing basis. If it uses insurtech or blockchain technology to do so, all the better. In many ways this has been a long time coming but it does now appear that a degree of traction is building, with industry loss warranties being the perfect test case. There remains much to do to achieve that goal but it is not something that the industry should shy away from.
The principal goal is to create a more open, transparent and efficient insurance market. As it stands, insurers are able to carry only as much risk as their regulators and internal risk management strategies will allow. The lack of liquidity of their investments in the current market means that, once capacity has been reached, the ability to quote on further business either ceases or terms become uncompetitive.
The problem is price dislocation between what the risk should be paying based on its inherent profile and what terms are being offered as a function of available capital.
Granted, exchange trading may not fully alleviate the issues associated with capacity. The counter-argument is there appears to be a significant number of third party capital providers desperate to deploy capital in to the market, which an exchange would undeniably be able to facilitate.
By increasing liquidity in the market the expectation would be that participants will be more willing to offer competitive quotes knowing that they are able to quickly trade positions should they get close to their own internal risk tolerances.
The ideal spot
Because of its rich history of innovation, there is a strong argument that Bermuda is the ideal place for such development. At the time of writing the Bermuda Stock Exchange (BSX) lists 574 ILS issuers, representing close to 95 percent of all international issuances, with $41 billion in market capital outstanding. In addition, Bermuda is home to growing fintech and insurtech industries.
One could well imagine that smart contracts in conjunction with blockchain-powered electronic marketplaces could be utilised to track trades and validate instantly which holders were on risk when a loss was incurred and what those losses are quantified as. It is tantalising to consider the opportunities for innovation and optimisation that could arise from a collaboration of traditional reinsurers, ILS funds, the BSX and fintech resources.
In many ways, Bermuda has always recognised the increasingly complex legal landscape of the reinsurance industry; first with the advent of the SPI in 2008, and more recently with the introduction of the Incorporated Segregated Accounts Companies (ISACs) Act 2019 and the Amendment Act 2019, which amends the Insurance Act 1978 to create the new Collateralized Insurer class.
These structures have the potential to facilitate new and evolving transactions. ISACs may enter into transactions among themselves, depending on the investment strategy being pursued by each and the target returns required by their particular investors. In such a context, trust and trading relationships may be easier to establish with each ISAC existing under the umbrella of the same ISAC company.
Collateralized Insurers are few in number at present, but there is an expectation that they will become more commonplace due to the advantages they offer over existing SPIs. The collateral package of collateral insurers is more flexible and contingent and longer tail, more complex risk can be written, whether as insurance or as swaps. The increased flexibility afforded to Collateralized Insurers could well facilitate the transactions desired to resolve the trapped collateral problem.
With investors looking for ways to increase returns and the perception that there is flight to quality currently taking place in the market, the rewards for solving this problem are potentially great.
In any event, Bermuda and its nimble and inventive insurance market is the ideal environment for exploring such solutions and meeting the challenges the industry faces.