The lure of rated paper

As previously documented in this publication, momentum seems to be growing towards some of the bigger and/or more innovative ILS funds exploring the possibility of forming their own reinsurers.

It seems the apparently unsolvable problem of trapped capital, which has grown into a real challenge for the insurance-linked securities (ILS) sector in the aftermath of the cat losses of 2017 and 2018, is probably the biggest driving force. But there are other motivations as well, including the increasingly sophisticated strategies of investors.

These potential startups would seek to secure a rating and write business backed by a well-capitalised balance sheet. Yet while the concept seems straightforward, the structure that may underpin such a formation could vary dramatically depending on the objectives of their investors. But the basic concept would be that it would allow a more efficient matching of risk with capital, offering investors and cedants the best of both worlds.

Bermuda-based ILS Capital has openly discussed the concept for some time, first outlining this as an ambition for the company in 2018 and discussing the idea in detail in the September issue of this publication. It remains committed to exploring the concept. But more recently, industry veteran Dirk Lohmann, who heads up the ILS business of global asset management group Schroders, has said that he is exploring the possibility of launching a new reinsurer on Bermuda with a minimum of $500 million in capital.

An asset class matures

Lohmann explains that ILS investors are becoming increasingly sophisticated and are open to investing in new ILS asset classes for longer durations. Thus the investment firm is exploring the launch of a rated reinsurer which takes the needs of some investors to what he calls a logical conclusion.

“We are looking at the possibility of creating something with permanent capital structure with a rated balance sheet, which would allow us to manage a portfolio of risk in a way that allows for all the various risk appetites of the investors we work with,” he says.

“It depends on an investor’s objectives. Some do not want to be investing in an operating business but they like the returns. For others, this might be a natural evolution into the industry.”

Lohmann’s ILS unit has been called Schroder Secquaero since the former acquired 100 percent of Lohmann’s Secquaero business in July this year. He says that Schroders has “deep” relationships with a number of sovereign funds, several of which have invested in the reinsurance space previously. “It is a question of looking at clients’ objectives and considering what we can deliver,” he says.

One possibility, Lohmann suggests, is that Schroders would play a central role in forming, managing and building a new reinsurer—but that over time this entity would take on a life of its own, with key functions moving in-house.

The team at Schroder Secquaero has the expertise to run a balance sheet reinsurer—Lohmann himself was the former chief executive of Converium, and he says that some recent hires have been made partly with this in mind. Stephan Ruoff, former CEO at Tokio Millennium Re (TMR), joined the company as deputy head in November 2018; Beat Holliger, an experienced executive who has previously worked at Munich Re and Swiss Re, joined in February.

“Stephan and I have both managed balance sheets in the past, and we also have a well-resourced actuarial side and deep risk-modelling capabilities,” Lohmann says. “We have a much broader set of capabilities than many ILS funds.”

He stresses that the thought process behind launching a balance sheet reinsurer is part of a wider process of broadening the scope of risks that his company can offer ILS investors. The company has also looked at ILS funds targeting the life re/insurance space, run-off, and opportunities in Lloyd’s.

“We are looking at this space very differently from what ILS has done traditionally,” Lohmann says. “Run-off is becoming a really interesting space, with much bigger deals being done.

“We are seeing a lot of capital pulling out of the Lloyd’s market. Could that be an opportunity for ILS capital? Apart from Nephila, no-one has done that. We need to see what Lloyd’s CEO John Neal’s plans are but it is certainly something we are looking at.”

Best of both worlds

The idea that ILS funds are headed in this direction is an increasingly hot topic for the industry.

Mike Van Slooten, head of market analysis at Aon Benfield, confirms that he is aware of a number of ILS funds pondering the move to creating a rated balance sheet reinsurer. He says that this could work in a number of ways, but it could effectively operate simply as a way of transferring the risk onto capital markets investors via a 100 percent quota share retrocessional deal.

“For the buyer, it is offering them something they are familiar with in the form of a rated counterparty,” Van Slooten says. “What happens behind the scenes is irrelevant to them but if another risk transfer is taking place that makes it more efficient—that can work for both parties.

“It is a way of achieving the best of both worlds—achieving maximum access to business at a low cost of capital.”

Eric Andersen, co-president of Aon Benfield, agrees that the structure of the market is changing and ILS funds creating rated carriers could become a logical conclusion of that process. He says that so-called alternative capital is now entering the market at many more points in an attempt to get closer to the risk—and the logical conclusion is that some ILS funds will look to launch rated carriers.

“They are increasingly moving down the chain and all the different forms of capital will increasingly blend,” Andersen says. “It is just different buckets of capital at the end of the day. But the system is built around that of the rated carrier and that might be the competitive advantage some seek.”

The challenge of trapped capital

Most commentators seem to agree that, while the changing focus and goals of investors are underpinning this as a long-term trend, one of the biggest drivers that has made this more of an urgent consideration for investors is the issue of trapped capital—and the challenge of solving that as a problem for ILS investors.

Peter Dunlop, partner at law firm Walkers Bermuda, says that 2017 and 2018 losses exposed the issue of trapped capital as a structural problem in deals that use special purpose insurers (SPIs) backed by alternative capital. He adds that while a number of parties are trying to solve this problem by altering so-called buffer tables, which determine at what exposure point capital gets trapped even if the full trigger has not been reached, there is no obvious solution to this problem in the long term.

“It is at the discretion of the buyer to release the capital and they will do so only when they are comfortable they have a final loss number,” Dunlop says. “But loss creep is unavoidable with some type of cat events and that shows that maybe these structures are less preferable to rated platforms on some risks.”

Dunlop says that while there is an aspiration in the market to solve the issue through uniform contract wordings, this will be very difficult. “That is why there is more talk about the possibility of creating rated balance sheets.”

Playing into this market sentiment, he praises moves by the Bermuda Monetary Authority (BMA) to create a new class of reinsurer, the regulation and capital requirements of which would be specifically designed to suit companies operating in the collateralised reinsurance space.

According to Dunlop, the idea is to fill a gap in the market that exists between the SPI model and the heavily regulated class 3a or 3b reinsurers. “As the nature of collateralised products has become more complex, especially with some players using outwards reinsurance as part of the collateral package, the need for something like this has become clear.

“We anticipate that although some players using the SPI structures may move up to use this, other players may move down and seek a lighter regulatory touch. But the BMA is very good at consulting with the market and will listen to what the market wants.”

Flexibility and fewer pitfalls

John Warwick, managing director and partner at ILS Capital, one of the firms looking at forming a rated carrier on Bermuda, says that a mixture of several trends is driving this thought process. He says that one of the big attractions of ILS capital is its flexibility for investors, but it would also solve the issue of trapped capital. “For this very reason, many other funds are now looking at this possibility,” he says.

Warwick adds that this would help overcome another perennial problem that funds face: having capital at their disposal that they cannot use. He says that last year’s renewals were very late, and a number of fund managers were left with unused funds which they then had no time to deploy elsewhere.

ILS Capital does not encounter this specific problem since it writes deals throughout the year, Warwick says. It has been working hard to resolve the challenge of trapped capital, in the way Dunlop suggests: by changing the way buffers work on contracts—increasing the point at which capital would need to be held and reducing the amount that would need to be kept.

According to Warwick, the problem on many deals has been that the syndicate managing agent has insisted on keeping 100 percent of the capital involved in a deal, despite there being little likelihood it would all be triggered.

He adds that ILS investors are seeking diversity across types of risk—partly because of disappointing rate increases on cat business, and partly to simply diversify their portfolios.

Some, he says, are considering investing in Lloyd’s, but the market remains inflexible on certain issues such as reporting and the levels of capital that need to be held on gross lines versus net.

This is another potential target for the ILS sector. Nephila Capital, the ILS specialist now owned by Markel, created a blueprint for ILS vehicles entering the Lloyd’s market when it launched Nephila’s Syndicate 2357 in 2013. It went a step further in September 2019 when it received regulatory approval to establish its own Lloyd’s managing agency: Nephila Syndicate Management. No ILS funds have yet followed—but alongside considering forming rated carriers, it must surely only be a matter of time.