ILS


Breaking the chains—can the ILS sector shake off the curse of trapped capital?

Trapped capital has emerged as the Achilles heel of the ILS sector, with the issue putting off more potential investors from entering the sector and causing financial and legal problems for fund managers. Bermuda:Re+ILS reports.

“Unless the market deals with it, the sector will be severely limited.”
Tom Libassi, ILS Capital Management

Transparency. Certainty. Liquidity. Three of the most important considerations in any asset class ultimately boil down to one thing: trust that when you are investing your money, you are fully aware of all potential outcomes and pitfalls relating to that capital.

In the real world, however, situations rarely pan out that neatly, as the realities of economic volatility and legal ambiguity bite. But it is something that all issuers of assets strive for and want to promote to potential investors.

In the light of this, the insurance-linked securities (ILS) market has a problem: a persistent, nagging issue which nibbles at the coat-tails of the sector and threatens to stymie its growth even as investors around the world hunt for attractive alternative assets in a period of persistently low yields.

That issue is trapped capital, when money tied up in an ILS structure becomes unavailable to investors for a significant period of time, due to uncertainty over the number and quantum of claims which have hit the vehicle.

Addressing the problem is of vital importance to the development of the sector, but can the industry assure investors that trapped capital won’t continue to rear its head in future funds?

“Reserving has never been the issue. It’s the buffering on top of the reserving that’s the problem.”

Finding solutions

ILS Capital Management, based in Hamilton, has been operating at the coalface of the issue for several years.

As one of the larger dedicated ILS fund managers, the company has had to tackle the issue both internally and with potential and current investors. For example, it has tried to find workable, durable solutions, such as its securitisation of 51 contracts potentially impacted by 18 catastrophe events since 2017, equivalent to 70 percent of total locked-up funds as of 2020.

But that doesn’t mean that the issue is going away. Tom Libassi, co-founder and managing partner of ILS Capital Management, said in an interview with Bermuda:Re+ILS that the problem is one of the biggest obstacles preventing the sector from reaching its full potential.

“I’ve been a very vocal advocate that trapped capital is a significant impediment to the growth of the sector. Unless the market deals with it, the sector will be severely limited.

“More investors that we’re talking to are listing trapped capital as a reason not to add capacity to the space, so it is a significant impediment to growth,” Libassi says.

Having capital tied up in trust accounts for years (many of the issues currently facing the market stem from Hurricane Irma claims from 2017, for example) puts the ILS market at a substantial disadvantage against other potential sources of risk capital such as reinsurance companies, claims Libassi.

While a reinsurance company can redeploy capital more effectively to other parts of the business once claims hit, ILS funds are left waiting for the outcomes of often-lengthy arbitration proceedings which further dampen investor returns. That means that the ILS market, despite having a more attractive base structure with lower operating costs, is put at a disadvantage.

“If you look at the returns, you’re going to find that the returns for ILS funds are below those of reinsurance companies in terms of return on equity. Also, a reinsurance company is at a cost disadvantage compared to an ILS fund,” he explains.

“Our costs are substantially lower than those of any Bermuda reinsurance company. So, if our returns are lower, and we’re doing something similar, it tells you that the impact of trapped capital is really weighing on the market and its returns.”

Modelling challenges

LIbassi says that part of the issue is that the pricing models used by ILS funds and others to value contracts were never meant to accurately reflect the actual risk of claims on any particular event.

He points to the broad spread of loss estimates from Typhoon Jebi in 2018 as an example of how general uncertainty over losses is impeding the ability of the sector to provide firm figures for investors and clients.

“It’s just a weakness of the overall structure and the complexity in these cases,” he says.

“Part of what’s been going on has been social inflation—lawsuits and so on. And that’s simply not captured in any of the models. I don’t think the models are meant for what we are trying to use them for.”

Libassi adds that the dynamic further hampered the ability of ILS funds to compete with reinsurance capital for risks, given that reinsurers are more readily able to deploy that capital back into other parts of the business.

“The reinsurance industry puts up reserves, and they change the reserves. But remember, they’re still using that money. It’s not as if the money went away—our money is stuck in a trust account.

“When it comes to the speed with which a reinsurance company deploys funds, they effectively have greater flexibility to continuously use that money. Reserving has never been the issue. It’s the buffering on top of the reserving that’s the problem,” he concluded.


Photo by Thom Milkovic on Unsplash

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SEPTEMBER 2021


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