Rules are there to be broken

The term ‘convergence’ has gone from buzzword to old hat and back to trendy again when it comes to the risk transfer industry in recent years.

Originally used to refer to money from the capital markets being put to work in the re/insurance sector via insurance-linked securities (ILS) or sidecars, convergence then became so commonplace and the mechanisms by which the money was invested so varied, that industry executives started using the word in the past tense.

Now a slightly new meaning is entering the industry’s parlance. Instead of talking about the industry as a whole, it is being used to refer to specific companies that are breaking the rules or blurring the boundaries.

No company epitomises innovation in convergence to a greater extent than ILS Capital Management, the Bermuda-based investment firm that melds the needs of traditional reinsurance buyers with the desires of capital market investors.

It transcends the limited property catastrophe-based products most players in this space deal in and packages risk in very different ways from others. As it explores the possibility of securing a rating, the company continues to challenge the norms about what constitutes traditional reinsurance or ILS—and what convergence can truly mean.

“People use the word convergence but, for us, that happened back in 1992 after Hurricane Andrew when money flooded into the market.

“That’s when our partner Don Kramer started Tempest Re and applied modern portfolio theory to the insurance market, bringing a Wall Street approach to the management of reinsurance risk,” says Tom Libassi, co-founder and managing partner of ILS Capital.

“The founding of Tempest Re was the real turning point. Our whole investment philosophy developed from there. Since then, things have become ever more sophisticated. What we are doing now dovetails with where we think the market will eventually go.

“I believe we are at a tipping point for this sector. I don’t think this market will just continue to grow steadily—it is about to rocket to new heights. If this is a $100 billion market now, it isn’t going to go to just $150 billion. We believe that, with true innovation and convergence, it has the potential to exceed $500 billion.”

All about the journey

ILS Capital has been on its own journey. Launched in 2011, the company initially managed the money of a handful of investors, using collateralised structures to cover a mixture of property-cat risks, marine and offshore energy.

Five years ago, Libassi and his co-founders Kramer and Paul Nealon made some fundamental changes to the company. They wanted to make its offering equally appealing to buyers of reinsurance and to investors seeking the inherently attractive characteristics that the reinsurance asset class offers, while also looking at the risk-return dynamic in a different way.

Nealon says that on one side of the business, they spent a lot of time speaking with investors.

“We asked them what they liked and what they did not like, and we took that on board. The original structure, which had been developed by reinsurance experts, made no sense to investors.

“We wanted to make our products and the language wrapped around them much more investor-friendly,” he adds.

On the other side of the business, Libassi explains, the company decided to hire reinsurance experts who knew their markets and the risks associated with them intimately. The company wanted to
write marine and offshore energy business—so it recruited experts in those fields.

“On that side, we need access to good risks; the best way to get it was by hiring well-connected, experienced underwriters and actuaries,” he says.

Finally, the firm continues to spend a lot of time talking with reinsurance brokers, many of whom had never looked closely at this fully collateralised space—especially for risks beyond property-cat.

“We realised that we could write a much broader portfolio of risk than we ever imagined, which was also very diversified. Our team has a long track record of committing capital to specific deals and knows the clients we wanted to work with,” Nealon says.

Some five years on, ILS Capital still sits apart from almost any other player in this space in two key ways: no other fund has such substantial books of business that are not property-cat; and no other fund packages the risks in a way that is so investor-orientated, with language they can understand.

Libassi stresses: “These are traditional reinsurance coverages from the buyer’s perspective—just fully collateralised. They are not index-linked contracts such as industry loss warranties or cat bonds.

“We were the first ILS manager to offer an indemnity-based product to the marine and offshore energy sector. While some others have entered this space over the past five years, there are not many.”

A rapidly growing niche

From having one marine client in 2013, ILS Capital now has around 15, which represents roughly 40 percent of its target clients in this sector.

In terms of the business’s entire portfolio, some 25 percent is made up of specialty marine and offshore energy business; 25 percent US insurance business (via a recent acquisition); 25 percent property business; and 25 percent property-cat business.

The company has grown exponentially since Libassi and Nealon joined. From assets under management of some $20 million in 2014, it is now approaching $400 million. It works with more than 200 investors, over 90 percent of which had never previously invested in an ILS fund, and has 14 people across three offices in London, Hamilton, and Greenwich.

Libassi explains that another factor that sets the business apart and has helped drive this growth, is the way it measures return on investment. Instead of measuring a contract’s attractiveness using solely traditional reinsurance metrics such as loss ratio, the team has incorporated traditional Wall Street risk and return metrics, such as Sharpe ratio and return on capital, into its diligence process.

These measurements factor in the risk of capital being ‘trapped’, something that has become a big problem for the ILS sector, especially in the aftermath of the heavy losses of 2017 and 2018. Libassi says ILS Capital has been focused on mitigating this issue since 2015.

“We structure our deals differently to try and ensure that investors get their money back faster and we better manage this issue. We have created total alignment of interests between ourselves and our investors,” he says.

“That is a very different way of thinking about it. With the Tianjin explosions in China and the Pemex offshore energy platform fire in 2015, we experienced first-hand the impact that trapped capital could have on our investors and have actively managed it since then. We have turned down some great deals because of that very issue.”

ILS Capital had exposure to the Tianjin explosions but still posted a positive return that year and underwrote the same deals the year after. Libassi says that this helped to reaffirm to the buyers that the company and its investors were here for the long haul.

“The view of some reinsurance buyers was that ILS investors were simply opportunistic. We overcame this by hiring the seasoned underwriters we have, and our continued support through 2015 and in subsequent years proved we are a long-term partner,” he recalls.

“That did us a lot of good in the long run. We learned some valuable lessons and tweaked the business model as a result.”

The value of the fund’s diversified strategy was borne out by the positive return of its specialty positions in both 2017 and 2018.

Rocking the boat

The company’s alternative approach to the market was again rewarded in 2018, when it took the unusual and somewhat bold move of acquiring a major stake in US auto insurer Producers National Corporation, based in Chicago, which owns five managing general agencies and three insurance companies. Prior to ILS Capital’s investment, the company was licensed to write business in eight states. Today the company is licensed in 12 and expects that number to increase to 17 by the end of the year.

Libassi says the venture came about after a reinsurance broker introduced the idea in 2017.

“After extensive research and brainstorming, the ILS Capital team devised a structure that would allow our investors to write this business via fully collateralised quota share agreements with the insurer covering certain portfolios of risk,” he explains.

ILS Capital’s investors are behind the equity investment the company has made in the insurer.

“That means our investors get returns from both equity ownership in the company and the quota share reinsurance contracts we write—fully aligning the interests of our investors, Producers National, and ILS Capital and ultimately giving us multiple ways to profit from this investment,” Libassi says.

He says the company felt this was a good time to be moving into the auto insurance business. After several years of very poor underwriting results, capacity has exited the sector and rates are starting to harden as a result.

“This is a true diversifier for our investors that offers very attractive returns. It is not diversifying just for the sake of diversification,” says Nealon.

ILS Capital has more innovations in the pipeline. For almost a year, the company has been exploring the possibility of getting a rating.

Likening it to the growth of alternative lenders in the bank debt market in the late 1990s, Libassi and Nealon insist that ILS can coexist with traditional reinsurance players. From the perspective of investors and buyers, little would change, but it would afford the company much more flexibility, mitigate the problem of trapped capital, and reduce expenses, they say.

To understand how this would work requires some mental gymnastics. ILS Capital’s investors, much as they do now, would invest in preference shares linked to reinsurance contracts. Additionally, they would invest in the equity of the new reinsurance company.

Buyers would have the option of either purchasing contracts backed by collateral, as they do now, or purchasing a traditional insurance contract backed by the full faith and credit of the rated reinsurance company. Where deals are triggered or contracts must pay out, the structure would allow the company the flexibility to avoid some of the downsides of collateralised deals.

“For our investors, each contract would be linked to preference shares, as it is now, but one subtle difference is that investors would have limited exposure to the equity of the company.

“What we would be doing would be very similar to fronting, and the economics of that are very attractive,” Libassi explains.

“The elephant in the room for ILS investors is trapped capital. While investors who committed at the beginning of 2018 were happy with their investment performance, earlier investors were frustrated with their inability to fully participate on attractive new investments due to their trapped capital.

“The team shared in earlier investors’ disappointment with adverse developments on 2017 contracts and the impact of trapped capital.

“The firm has still not paid claims for 2017 events equal to the initial reserves established in 2017. We believe that if ILS is truly about providing investors with attractive non-correlated exposures, in what way does the nature of the transforming vehicle matter?” he says.

“By converting our class 3a collateralised reinsurer into a class 4, we can become much more capital-efficient and also write attractive new business that doesn’t currently meet the firm’s return on capital criteria. By integrating a rated balance sheet company into the fund, we give investors the best of both worlds: attractive non-correlated returns offered by ILS with increased capital efficiency, lower costs and alignment of interests.”

Nealon argues that this structure has the potential to significantly grow the entire market.

“I don’t see this as competing with the traditional players. It is just taking a different approach to matching capital to risk,” he says.

“You are selling cedants traditional contracts backed by a balance sheet but at the back end, investors are investing in specific contracts and getting non-correlated returns. If you think about it, it’s the Holy Grail of this business.”