Trapped capital: ILS is the answer
The re/insurance industry faces a considerable challenge around trapped capital. ILS Capital Management says it has looked at a number of potential solutions, but only one has worked: selling it to investors packaged as ILS. Bermuda:Re+ILS reports.
When ILS Capital Management completed its $57 million offering of 5.50 percent asset-backed notes in August, it was tacitly proposing a solution to a $15 billion problem that affects many re/insurers globally: trapped capital.
ILS Capital’s securitisation of the residual value of trust accounts supporting reinsurance contracts is the first-ever securitisation of ‘trapped’ capital—investor funds that are temporarily held by counterparties and thus unavailable for reinvestment until insurance claims are settled.
In the banking world, the asset-backed securities (ABS) market has been very creative about securitising cashflows from all sorts of assets, be that credit cards, mortgages or auto loans. It has shown that anything that generates a cashflow can be securitised, and ILS Capital has reinforced this message.
Tom Libassi, co-founder and managing partner of ILS Capital, says: “We have looked at various different ways to solve our trapped capital problem and this is the only way we have found that works.”
How it works
ILS Capital’s deal securitises ILS Capital’s trapped capital from trades mostly from 2017 and 2018, with one or two early 2019 trades also included. It includes 51 contracts potentially impacted by 18 catastrophe events and represents 70 percent of the total trapped capital across ILS Capital funds as of January 1, 2020.
The underlying contracts had an average life of 30 months and were packaged and sold to Parliament Street Finance, a newly formed special purpose vehicle subsidiary, which then issued debt to investors in the form of notes.
The deal facilitates a strategic shift for ILS Capital, which has filed a modified business plan with the Bermuda Monetary Authority to allow it to reduce its reliance on the collateralised reinsurance business model, Libassi says.
“This was a way to monetise legacy trapped capital exposure that we will not be focusing on any more,” he explains.
The larger significance of the trade, however, may be for the broader re/insurance community, which could benefit from freeing up more of its own trapped capital if other issuers follow suit with their own trades.
“By unlocking capital that would otherwise be kept from being redeployed, this transaction gets money back into the hands of our investors more quickly, making it available for new investments while still providing our investors with potential upside,” he says.
“The challenge will be to scale it to a size that gets those huge ABS funds interested.”
Tom Libassi, ILS Capital
ILS Capital estimates there is around $15 billion of trapped capital, globally, suggesting there are plenty of other assets that could be securitised in similar transactions.
The fact that ILS Capital has done this transaction means all the documents have been drafted, which makes it easier for others to follow.
Libassi believes that, with ILS Capital having laid the groundwork, future trades could include a broader selection of assets, and be easier to structure.
“In the future it should be possible to include contracts of up to three-and-a-half years, and the deals could be turned around faster, maybe six months after a contract matures,” he says.
Libassi reports that the ILS Capital notes were bought by a range of investors, including insurance companies and money managers. “We did not sell this to the insurance-linked securities (ILS) funds, we focused more on the classic ABS investors which have no exposure to this space,” he says.
“They liked that it was not correlated with the other ABS they hold.”
He argues the 5.5 percent return represents a very attractive return for investors in the current interest rate environment, but concedes the ILS Capital deal was not big enough to be of interest to all the ABS buyers.
“The ABS market is huge and can easily absorb $10 billion deals,” he says.
“If others in the market follow suit with similar types of transactions, the challenge will be to scale it to a size that gets those huge ABS funds interested.
“Pension funds could be very interested in this kind of structure but a deal of this size is too small to be of interest to them.
“I expect the ILS market to grow dramatically, especially given that it is currently very small. It is currently around $100 billion, or approximately the size the high yield market was in the mid-1980s.
“Since then the high yield market has grown to $2 trillion, which gives a sense of the potential for growth for ILS. If China opened up its reinsurance market that alone could double the size of ILS.”
Trapped capital could play a role in driving this growth if more issuers follow ILS Capital’s lead and bring their own deals to market, although Libassi admits the supply of trapped capital to be securitised can be variable.
“Before 2017 we had a period of around 10 years when there were no major hurricanes, so it is possible to go for extended periods when trapped capital is not much of an issue,” he says.
“That will be a challenge when it comes to scaling up trades based on trapped capital.”
In the short term, however, there is plenty of trapped capital to work with, while the broader market conditions—super low interest rates and a hardening insurance market—provide a favourable backdrop.
“With the market hardening this is a great time to be looking at trades like this,” says Libassi.
ILS Capital was advised by BNP Paribas, which served as sole structuring advisor and sole placement agent. Goodwin Procter and ASW Law served as its legal advisors, while Mayer Brown provided legal counsel to the investors in the transaction.
The transaction was marketed by BNP Paribas’ debt private placements and ABS syndicate desks. It was placed with investors from global and regional asset managers and insurance companies.