Casualty ILS to face real test when forward exit options mature

Forward exit options have helped unlock investor appetite for casualty insurance-linked securities (ILS), but the market has yet to see how many investors will exercise those arrangements when transactions reach maturity, attendees at ILS Bermuda Convergence, held October 12-14, heard.

The structures have addressed one of the longstanding challenges of casualty ILS: how investors can recover capital tied to liabilities that may take years to settle.

Speaking during a panel discussion, which was moderated by Cate Cocks, managing director at Howden Capital Markets and Advisory, Philippe Trahan, co-founder and co-CEO of Calidris Investment Partners, said incorporating an exit mechanism at the outset had transformed the investment proposition.

“The beauty with these sidecars is that you get it at book value. You will exit. You know when you exit. You know how the price will be set,” he said.

However, the arrangements introduce their own uncertainties, particularly where the exit price is calculated as a percentage of outstanding reserves.

“The big risk is that your counterparties start playing around with the reserves,” Trahan warned.

Casualty claims can take years to develop, leaving considerable uncertainty around ultimate losses when investors seek to exit. Trahan noted that counterparties may maintain their initial reserving assumptions for several years before sufficient claims experience emerges.

Matthew Ball, senior managing director at WTW, questioned how the arrangements would perform once investors faced the actual economics of exiting.

“I think it'll be interesting to see how these things play out when these deals come to their turn, and how many investors will end up taking the option when they see a potential internal rate of return (IRR) drag,” he said.

Ball suggested that forward exit structures could be refined, including greater consideration of whether exit premiums should be calculated against discounted rather than undiscounted reserves.

He also identified a fundamental question over which party’s reserves should determine the transaction price, particularly where different reserving approaches could materially affect investor returns.

Counterparty credit risk presents another challenge. Asked whether a legacy reinsurer providing a forward exit option could fail before the arrangement matures, Nathan Lord, co-founder and head of insurance-linked securities at Jaffa Capital, acknowledged the possibility.

“We've seen the legacy space is full of failed experiments. A number of them have gone bust before they met all of their obligations,” he said.

Nevertheless, Lord argued that an exit commitment from a well-capitalised legacy reinsurer could still provide meaningful protection against long-tail uncertainty.

Trahan said Calidris had addressed this exposure in a previous transaction by arranging for its underwriting partner to assume the reserves if the legacy provider failed to honour its commitment.

The panel also discussed the Bermuda Monetary Authority’s consideration of capital requirements associated with forward exit commitments, which could influence the economics of future transactions.

For Ball, the next phase of development will depend on practical experience as existing structures reach their exit dates.

“I think the next evolution will be how are investors and sponsors exiting, recycling the collateral,” he said.

“I think the product will get better as people go through that. Just like the collateralised reinsurance product has got better after some [capital] was trapped in the property side a few years back.”

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