Insurance-linked securities (ILS) are currently estimated to provide reinsurance capital in the range of $88bn (according to AM Best and Guy Carpenter) to $93bn (according to Aon). However, recent Nat CAT losses have uncovered new issues and expectations for the ILS market.
The ILS market was tested in recent years – experiencing $220bn in losses from July 2017 to December 2018. “Overall, the ILS market performed as it was designed because it proved to be a reliable provider of collateralised reinsurance. Even after a series of severe catastrophe events, there appears to be ample capacity in all but the hardest hit segments/regions such as the aggregate retro market and, possibly, loss-affected areas such as in Florida and Japan,” said AM Best in a recent report.
Finding mutual benefit between cedants and investors
The recent extreme Nat CAT losses have also highlighted the fact that in ILS, what is good for cedants is not always good for investors, and vice versa. Still, cedants and investors have to find a mutually beneficial meeting ground to coexist.
With ILS, cedants face the real possibility of tail risk when collateral is returned to investors before losses have fully developed. This issue undoubtedly cropped up on several occasions over the past few years given the extreme loss creep associated with catastrophic events like hurricane Irma and typhoon Jebi.
These loss events brought the use of buffer loss tables, the mechanism that governs the schedule for collateral release back to investors, into focus, AM Best added. “It is now clearer to ILS market participants that the release of collateral based on buffer loss tables does not necessarily absolve a collateralised reinsurer from its obligations to cedants pursuant to reinsurance agreements.
“The legal community has chimed in to say that a commutation agreement is necessary to remove all doubt about further payments to cedants given adverse loss development. It also is clearer that buffer loss tables may indeed get more conservative or, at the very least, ILS managers will have to spend more time discussing why they should remain at current levels,” said the report.
Further, the issue of trapped capital remains. Aon estimates a total of $15bn in trapped capital, the result of cedants making sure that collateral sticks around until full losses develop. As the buffer loss tables are factors applied to projected ultimate losses, the resulting collateral trapped under reinsurance transactions can be excessive if cedants are fearful or genuinely uncertain about ultimate losses. M