Thinking inside the box: parametric risk and ILS
R-E-S-P-E-C-T (find out what it means to investors)
The spectre of trapped capital has heightened the desire for efficiency, according to a panel discussion during ILS Bermuda’s Convergence conference.
There are various ways to manage capital efficiently and thus calm the nerves of an investor in insurance-linked securities (ILS). According to Michael Hamer, partner and senior analyst at Albourne, this topic has become a focus for investors because, over the last four or five years, substantial amounts of invested capital has become ‘trapped’.
As moderator of the panel “Reduce, reuse, recycle” at ILS Bermuda’s Convergence conference, Hamer began with a positive message.
“A number of managers and service providers have been very active in trying to develop ways of making the investments more efficient. One of the areas that in particular has really grown quite rapidly is providing investors with a significant amount of non-recourse leverage through the use of rate and balance sheets, and tail hedges,” Hamer said.
“We have a large and well-diversified portfolio of traditional property cat risks.”
The right amount of collateral
Introducing the first panellist, Hamer said that Butch Agnew, portfolio manager at Arch Reinsurance, is part of the team responsible for developing and managing the company’s collateralised fronting of an ILS facilitation platform.
Arch provides “facilitation mechanism”, Agnew said, to allow the ILS managers it works with to access the “traditional” reinsurance space.
“The end goal is that we help facilitate pairing risk to capital in the most efficient way. It’s part of our DNA, what we do every day and it’s what we strive for on an ongoing and continuous basis,” he said.
Citing a recent report from Aon Securities, Agnew noted its estimate that the total capacity of the ILS capital market is about $95 billion, composed of collateralised reinsurance, catastrophe bonds, industry loss warranties (ILWs) and sidecars. Omitting cat bonds and sidecars, Agnew said, that leaves around $52 billion deployed supporting collateralised reinsurance transactions and ILWs.
“That’s the primary space where we try to facilitate and provide the tools and mechanisms to allow ILS managers to access and deploy capital,” he said.
Fronting is a “complicated business” that requires a significant commitment and a very long-term view of portfolios that Arch allows its ILS managers to write.
“You need long-term relationships that involve a lot of trust. And you have to have a knowledgeable and experienced team that understands the risks you’re allowing those ILS managers to take, because you’re a participant in that activity,” Agnew said.
“It also requires a significant investment in technology and an extremely efficient mid and back office to facilitate that interaction. And lastly, and importantly, you need to have a strong balance sheet and a strong financial strength rating to allow that facilitation to occur, where the cedants in the market will accept your participation in the process.”
There are two main ways that Arch creates capital efficiency, he said. The first is through digitisation and automated straight-through processing, for which it uses a cloud-based online platform. This facilitates fronting activity between the ILS managers and Arch.
“It involves a high-performance calculation engine, integrated premium and claim payment processes, as well as interfacing with the banking trustee custodians to get a real-time feed of all of the information into the system, so that there’s one view of the truth between the ILS managers and the front-end carrier,” Agnew said.
Arch has invested time in developing that technology, and then in creating connections through application programming interfaces between its internal systems.
“In one direction, we can record all the contracts to be fronted in the finance and risk management systems of the greater balance sheet, but equally we can give the ILS managers access to that information in real time,” he said.
Arch is also pulling all the relevant claim and premium information back into the system, which gives the ILS managers the ability to make better decisions.
“And so we give them, through the automated collateral calculations, which we can do every day, the ability to price marginally every deal against an active portfolio, but also proxy portfolios to decide, ‘is this a risk that makes sense to front on a rated balance sheet, or is there another mechanism that I can use?’. And we’re a partner in providing those tools to them.”
The upshot of having “real-time, in-place calculations” is that Arch has “just the right amount of collateral” at every point in time in the lifecycle of the underlying contracts and the portfolio itself.
The second way Arch creates capital efficiency, Agnew said, is through non-recourse leverage.
“We have a large and well-diversified portfolio of traditional property cat risks. We can provide leverage to the ILS managers, so that they can participate unconstrained in any way by the traditional excess-of-loss programmes without the risk of not getting the proper economics out of it,” he said.
“This basically gives the ILS managers the ability to participate and create their own unique ‘alpha’ for the end-investors. And that’s super important.”
The contracts are primarily sourced by the ILS managers, he said, but Arch can augment, from time to time, supplemental risks that might be beneficial to the portfolio. The “net interesting outcome” of providing the leverage to the ILS community is that it creates an “incredible” alignment of interests between the fronting carrier and the ILS manager to produce “optimised and outperforming” portfolios. Crucially, Arch is a participant in the risk profile of all the portfolios that it fronts.
Hamer asked whether Arch participates in a portfolio other than by taking a tail hedge. Agnew replied, “No, it’s the tail risk that we take as part of the process.”
“In good years, you have the ability to leverage the invested assets.”
Laura Bonanno, a senior vice president of Capital Partners at RenaissanceRe, noted Hamer’s interest in discussing DaVinci Reinsurance, which operates like a balance-sheet reinsurance sidecar.
“Before I dig into the questions on the RenRe vehicles, and specifically DaVinci, it’s important to note that RenRe has been managing capital for third-party companies for over 20 years, on the back of RenaissanceRe which has been in the market for nearly 30 years,” Bonanno said.
“Part of our corporate strategy is having an integrated system and we do this by employing multiple balance sheets, not only some of the rated vehicles, but also in fund format. Our goal is really maximising the ability to match the most desirable risk with the most efficient capital. And we’ve done that throughout our period of time in existence, typically after a large event that’s happened in the market; either there’s some sort of dislocation or we’ll find an opportunity to provide capacity to the market and work with cedants to do that, and backed by partners that we find to support that risk. We are in step with our partners—we invest behind our vehicles, and we grow with them.”
Capital Partners uses both rated ILS vehicles (DaVinci, RenaissanceRe, Top Layer and Vermeer) and ILS funds (Fontana, Medici and Upsilon).
“DaVinci is our flagship vehicle that sits alongside RenaissanceRe on the global property cat book. It has its own paper, it’s rated ‘a’ with AM Best and ‘a+’ with S&P,” Bonanno said.
“It was a really good marriage between providing the underlying insurance company with access to capacity and also minimising their counterparty risk. Not only do they have RenaissanceRe backing their reinsurance programme, they have several large institutional investors via DaVinci.”
RenaissanceRe’s $11 billion of capital under management and access to a diverse portfolio of risk it provides are two of Capital Partners’ key strengths, she continued.
“If you don’t have a rated carrier in your vehicle opportunities for cedants, you may be missing out on the opportunity to add that kind of risk to the overall portfolio. And having selective underwriting, being able to apply that across all of the vehicles that we have means we are able to leverage a lot from the RenaissanceRe corporate level.”
Another significant feature of Capital Partners’ approach is its alignment of interests.
“We have a billion dollars of our own capital sitting alongside all of our investors across the vehicles. That alignment of interest is pretty key to our partners and means that when they have a tough year, we also have a tough year.”
She clarified what the ability to leverage capital means to Capital Partners.
“There are three things: operational leverage, meaning you can write significantly more limit against the capital in a vehicle, depending on the rating you get, which is not something you necessarily have in a collateralised structure; you have the ability to embed some financial leverage within that vehicle, which gives you an additional kick up on that capital for limit; and finally, in good years, you have the ability to leverage the invested assets.”
A rating provides an independent, objective view of a company’s balance sheet, which is important to Capital Partners’ cedants, she said, adding that the concept of ‘trapped’ collateral “doesn’t really exist” within a rated vehicle.
“On the underwriting side, when you want to trade forward, you have a little more certainty as to how to do that in a renewal period, which you don’t necessarily have in the collateralised space, where you have to go back and raise capital if you have side-pocketed amounts or trapped collateral. One of the benefits on the flip side to that is liquidity. Typically, these are private equity vehicles, and you don’t have the liquidity as an investor to get in monthly or quarterly and, in some cases, not even annually. So it’s really for an investor that has a long-term view of the asset class. If they are interested in participating in the asset class, but want something a little more liquid, then typically we would guide them to the cat bond space or to an investment in DaVinci with us.”
Hamer summarised the discussion thus far as creating leverage in different ways, with RenRe using an integrated and rated balance sheet, and Arch offering a third-party solution for that.
“Lloyd’s has mutual capital at the top of the stack that all of its members can access.”
Lloyd’s ‘hybrid’ approach
Turning to Tim Shreeve, head of platform development at Ariel Re, Hamer noted how the company, as manager of a Lloyd’s syndicate (1910), had recently joined the Standards Board for Alternative Investments as a fund manager. He asked Shreeve to describe the relationship with Lloyd’s that allows Ariel to provide capital efficiency through non-recourse leverage and invested liquidity.
“I’m quite conscious of being the only person on the panel at a Bermuda conference talking about a solution that’s not in Bermuda,” Shreeve said, adding that Lloyd’s is a “hybrid” of the approaches described by the panellists from Arch and RenRe.
“Lloyd’s has mutual capital at the top of the stack that all of its members can access, which means they can operate different businesses within the marketplace.”
Lloyd’s underwrites about £40 billion of premium annually and has over 200 lines of business, meaning syndicates can enjoy a diversified portfolio. Moreover, the rating that all of the members have access to is an ‘a’. Capital is calculated at the ‘1 in 200’ loss level plus a multiplying factor of 35 percent.
Diversification supports efficiency, Shreeve said, and in a number of ways. For example, syndicates can invest, not only with cash, Treasury bills or cash equivalents, but also with equities, debt and LLCs. Another advantage of Lloyd’s, he said, is a “robust” third party governance framework, and that each syndicate is run by a managing agency, which has its own responsibilities to Lloyd’s as well as to the syndicate’s investors. “So each managing agent is a fiduciary,” he added.
“The capital at Lloyd’s is mutual and it’s there to support members’ liabilities if their capital is exhausted. So it acts like the tail risk facility that Arch provides.”
Another efficiency with Lloyd’s is that it is “relatively cheap”, Shreeve said, in terms of how much it costs the underwriter. “The fully baked Lloyd’s cost is about 1 percent of premium and most of the fees Lloyd’s charges are based on the premium. And there’s no fee on any capital held back,” he said.
The best way to invest at Lloyd’s, he said, is with a long-term outlook, “a bit like a rated balance sheet”, and to think of the process as making consecutive annual investments.
“The release profile of the asset has a tail to it. You know that your capital is going to be trapped at the outset of the investment, but it has a fairly typical profile that it follows. After three-and-a-half years, if you choose to divest, you get all of your money back through a mechanism called ‘reinsurance to close’,” he said.
Hamer said a Lloyd’s syndicate “looks just like an ILS Fund”, with Lloyd’s itself acting as the fronting company, and the central fund acting as the tail hedge.
“It’s interesting when comparing these structures to identify who’s playing what role,” Hamer said. “In the Arch structure, Arch is taking the tail hedge and providing the front; in the RenRe role, the fronting is actually being done by the fund, and the tail hedge is essentially the cedants because, to the extent that if you ever were to use up all your capital, then they just wouldn’t get paid.”
Bonanno agreed: “In the rated vehicle, the contracts are written on the paper of that vehicle. So yes, it takes the tail.”
“We like reinsurance companies for their global access to risk.”
The attraction of reinsurance
Hamer then asked Dominik Hagedorn, co-founder of Tangency Capital, how investing in ‘quota shares’ provides an attractive source of non-recourse leverage.
“We like reinsurance companies for their global access to risk,” Hagedorn said. “We like them for the global diversification that they offer and for the alignment of interests that they provide.”
He highlighted two ways that Tangency’s approach creates capital efficiency through non-recourse leverage.
“That’s the phrase that’s been mentioned a couple of times, but we think of it more as ‘economic capitalisation’ of the risk. Reinsurance companies capitalise that business based on rating agency and regulatory requirements, and their own economic considerations. By investing with reinsurance companies in bespoke quota shares, we follow that same model, in that we capitalise a cell that backs a quota share reinsurance agreement on a subject business that we’ve identified and agreed on with a counterparty, up to a certain return period, which is subject to negotiation, to risk appetite, to the right fit for the fund, and other aspects.”
The other feature of capital efficiency is “buffer tables” or “rolling capital”, he continued.
“At the end of a risk period in many ILS structures, we look at reserves and employ a buffer table or buffer percentage against those reserves to allow for adverse development post the risk period. The industry more broadly has devised an arrangement whereby, so long as investors stay invested with a counterparty and on a certain subject business, rolling happens in excess of reserves to do away with the buffer, which is obviously quite helpful. If you’re able to deploy capital when it’s needed the most, which is in times of dislocation (as we are seeing at the moment) or, more broadly, this avoids a situation where a small loss may affect your ‘deployability’ in subsequent years.”
Hamer asked whether, in that structure, the provider of the tail hedge is the cedant. Hagedorn replied it is the reinsurance counterparty, which is the “right one” in the industry to hold the risk.
“We’re pretty flexible with how we can roll capital.”
John Modin, president of Mt. Logan Re, the third-party capital arm of Everest Re, asked delegates to imagine a Venn diagram, with the Everest logo and the Mt. Logan logo, and the intersection as their investors.
“Mt. Logan is a risk-sharing vehicle that provides institutional investors access to the Everest Re global catastrophe reinsurance portfolio—1,000s of layers and hundreds of cedants. It’s set up to be really flexible from an investor perspective,” he said.
He stressed the attraction of the seasonal basis of Mt. Logan’s approach.
“If someone enters on January 1, and it was a treaty that was predominantly North Atlantic wind exposed, most of the premiums already earned coming up to June 1, that’s helpful. No ramp, come right in,” he said.
Mt. Logan doesn’t have “financial leverage”, he said, but it does have operating leverage.
“For every dollar of capital, investors have multiple first-event limits based on that. Some strategies have more leverage, some have less, but whatever that ratio is, first event limits:capital, you can double it for the total limits because our portfolio was primarily ‘per occurrence’ to limit underlying contracts.
“Everest takes on most—about 80 percent—of the portfolio that it writes and so there’s an alignment of interest in that only about 20 percent is ceded to Mt. Logan. In addition, it takes back the tail. So, if in the remote scenario where losses exceed the capital, that would go back to Everest, but investors get the benefit of that leverage right out of the gate. We don’t have a rating, we don’t need one because we have one ceding client, Everest. That means we’re not facing the market.”
During the life of an investment, Mt. Logan is very flexible with respect to rolling capital from prior accident years into current accident years, he said.
“Most of our capital today is single investor segregated, and with a single cedant, we’re pretty flexible with how we can roll capital. We reserve the right to set up a side pocket but, for the most part, we do not because we can manage that relationship with one pool of capital. A single cedant and single investor means trapping is something that rarely will come up.”
Not having to provide collateral and having access to a “super-diversified” portfolio benefits investors, he said, because it allows lower rate online contracts to be in the portfolio.
“We set this up to be investor friendly. It’s been around for 10 years; we have investors that have been there from the beginning, and we’re looking forward to our next 10 years.”
Hamer noted that leverage improves the efficiency of capital going into a transaction, but the issue still is coming out of it.
Modin replied: “If most of the capital is rolled forward, that’s when the trapping risk is very low. If there’s a significant redemption, then we have that conversation and there could be buffer tables that are in place. In that case, Everest will not take the counterparty credit risk of having collateral that’s not sufficient.”
ILS Bermuda, Albourne, Arch Reinsurance, Capital Partners, RenaissanceRe, Ariel Re, Tangency Capital, Everest Re