While Covid-19 has caused little disruption in the ILS market to date, Securis’ Richard Godfrey says nonetheless, it is worth considering what issues have arisen and what they could mean in terms of the future interaction between the ILS and (re)insurance markets.

At Securis we think of the relationship between the two markets as symbiotic. Reinsurance and insurance companies benefit from access to a specialist, additional source of risk transfer capacity, brokers benefit from additional products to add to their range, whilst in turn our investors benefit from access to sources of risk which diversify their broader investment portfolios.

Richard Godfrey, deputy underwriting officer at Securis

For this relationship to thrive and endure it is essential that the differences between the two markets are appreciated. Investors have an expectation of adherence to capital markets standards of practice and transparency, and do not appreciate nasty surprises. The conditions attaching to ILS capital, which is temporary, differ to those of the permanent equity capital underpinning conventional (re)insurers. Different capital necessitates different product. For ILS involvement to be sustainable it is essential there is confidence transactions perform as intended, in particular relating to the basis of return of capital.

The ILS market is often characterized as an interface between the broad financial markets and the (re)insurance market, where capital markets standards of documentation and discipline meet the arguably more relaxed and interpretive practices of the (re)insurance industry. In the earlier days of ILS it appeared that capital markets standards might prevail, the predominant instrument being the catastrophe bond, a true “security” structured and documented to the standards of the wider debt markets.

However, as the ILS market became established, and investor appetite increased, new instruments accessing risk in smaller packages and at lesser cost were needed. So collateralized reinsurance was born, shifting to simpler “reinsurance-like” documentation and introducing an element of trust: the investor’s assets are placed in trust for the benefit of the protection buyer, thus the investor is reliant on the reinsured agreeing to release those assets back to the investor as and when stipulated.

This aspect raises a question. When something unanticipated and still unfolding, such as Covid-19, comes along, does the reinsured abide with the intention of the transaction, or, on the basis possession is 9/10ths of the law, hang on to the assets sitting in trust whilst it waits to see how events will develop, sometimes with little basis for asserting a loss would ultimately be covered anyway? Collateralized reinsurance transactions are not generally “follow the fortunes” based, but rather cover specified perils and lines of business.

So whether Covid-related losses are recoverable under a particular transaction should be straight forward to agree upon. Yet we see instances where collateral returns are being delayed, perhaps on account of concerns such as underlying insurance coverage uncertainties, loss aggregation and assignment of date of loss – all of which may deter cedents from submitting loss estimates for the purpose of the collateral release calculation and thus releasing collateral when contractually due.

So what does an ILS fund do when collateral is not returned when it believes due? Traditional reinsurance is a promise to pay by the reinsurer; collateralized reinsurance is effectively a promise by the reinsured to return collateral.

So the investor may have to fight to recover the collateral. Here another hangover from reinsurance practice comes into play. Arbitration is typically the default method of dispute resolution in traditional reinsurance contracts, but is a lengthy, complicated and expensive process, thus handing the cedent a strong near-term hand. Matters such as these are, we believe, a reason why it is essential to the future health and vitality of the collateralized reinsurance market that stronger process is introduced into contractual documentation and structure.

Looking ahead, we see items such as more appropriate dispute resolution mechanisms, mechanisms to smooth collateral release, and the removal of disparity between cedents’ public reporting and loss reserving for collateral requirement calculations, as crucial to maintaining the compact that exists between reinsured and investor. If not, we may risk ILS capital becoming disillusioned with standards of practice, with consequences that may not be to the benefit of protection buyers and intermediaries.