15 April 2014ILS

The ILS ‘explosion’: getting it right

For insurers and investors alike, the right choice of trustee/agent administering the ILS structure is vitally important, as Alex Tsarnas and Erin Courcey explain.

It has become almost a cliché to describe the growth of the insurance-linked securities (ILS) market as explosive. As with so many clichés, however, this one springs from a germ of truth: Launched only in the 1990s, the ILS market is today estimated at $50 billion in value and is expected to grow to $150 billion by 2018, according to BNY Mellon’s own estimates. Explosive indeed.

The reasons are evident. The returns on ILS—uncorrelated to other asset classes—tend to be higher than the modest interest rates investors find today. At the same time, insurers see ILS as a new source of capital, an alternative pathway for transferring risk and thereby minimising liability. These two driving forces—investors’ thirst for yield and insurers’ necessity to diversify risk—meet in the capital markets in the form of a range of special-purpose vehicles and trust structures.

It is at this point of convergence that a key player enters the equation: the service provider, that is, the trustee or agent administering the ILS structure. For insurers and investors alike, the choice of trustee/agent is of vital importance, and the experience and capabilities of the institution providing the services warrant close and thorough attention.

Service provider 101

What is so important about this basically administrative function? The most essential attribute for a service provider is financial soundness. Precisely because these transactions involve risk-based products, risk mitigation needs to be front and centre, and that means that the service provider foundation should be based on financial integrity. The servicing institution is responsible for providing operational expertise, efficiency, and responsiveness in execution and delivery that can help minimise operational risk and maximise value to the participants in ILS financing. Doing so requires a formidable collection of resources and capabilities.

Just consider the numerous and varied roles the service provider undertakes in carrying out the administrative responsibilities that support ILS transactions—collateral agent (or collateral trustee), indenture trustee, registrar, paying agent—all of which the provider must execute with expertise and efficiency.

For example, the collateral agent that administers the collateral trust for a catastrophe bond must effectively leverage its resources not only to safe-keep and administer assets, but also to enforce security over assets—if and when required—in accordance with transactional agreements and potentially complex legal and jurisdictional requirements. In addition, the scale of the service provider’s capabilities must be sufficiently comprehensive to manage the operational, credit and counterparty requirements inherent in different types of asset classes.

In the trustee role for a cat bond indenture, the service provider must carry out its duties and contractual obligations to ensure the integrity of the debt issuance and ultimately to represent bondholders’ interests in accordance with the transactional agreements. Key to this function is the service provider’s reputation and level of expertise—particularly essential now, when the rapid growth of ILS has attracted a new cast of players and intermediaries, many of them novice participants in the market. An established reputation and dedicated expertise can bolster the overall attractiveness of this asset class to investors and thereby contribute to the success of the issuer’s financing objectives.

In addition, the service provider, as registrar, is tasked with keeping records of bondholders and shareholders. The paying agent serves as the designated disburser of coupon and principal payments to the security holders on behalf of the issuer. Clearly, carrying out both the record-keeping and disbursement tasks, as well as the associated accounting responsibilities, requires that the service provider possesses a high calibre of technology and information systems.

Each of these varied responsibilities requires multiple, highly specialised transactional functions executed across a diverse palette of special-purpose structures and supported by a range of capabilities in multiple legal jurisdictions and multiple currencies. It is a big job—complex and often challenging.

A case in point is the administration of cat bonds. Inherently no more demanding to administer than most other structured products, cat bonds exhibit a number of features that are unique to their profile and purpose—for example, quarterly debt service payments and monthly and sometimes weekly as well as quarterly reporting requirements.

The cat bond service provider will also need to process the income payment earned on the collateral pool concurrently with the payment of accrued interest on the bond—the interest spread or risk spread. In other words, the service provider must disburse a payment that is an aggregate amount of collateral yield and interest on the bond. The service provider will also need to confirm the catastrophe event notice resulting from a trigger event and then, if applicable, to wind down the transaction by liquidating the collateral, doing the markdown, and making payment. These are just a few of the administration demands the cat bond service provider must execute efficiently.

How, and how well, this service administration task is executed can affect the operational and financial soundness of the cat bond or any other ILS financing. That is why it is a job that has to be done right. If not, the consequences can be substantial.

So, what does it take to do the job right, and what qualities and capabilities should you look for when choosing a service provider to support your ILS activity?

Core competencies: getting it right

The first essential is the service provider’s product and market expertise, gained—and proven—through experience in administering risk transfer transactions across a range of asset classes and markets. As a result of this experience, the service provider should also demonstrate a strong familiarity with ILS market participants and with their needs and concerns—a necessity in accommodating tri-party agreements.

The service provider’s expertise will need to be represented in all requisite systems, procedures, and methodologies for carrying out all the functions of the varied service and administrative responsibilities. That means—at a minimum—delivery of superior operational capabilities, accounting, reporting, and customer service for the full range of structures. To support those capabilities, skilled professionals who have done the work to a consistently high standard, who know the market and the players, and who understand the complexities of the transaction documentation involved are essential. Knowledgeable professionals who service these complex structures and are well versed in the process of document negotiation will help the smooth launch of your ILS transaction.

Furthermore, the service provider should be focused on the service administration aspects of the operation—and nothing more. A service provider that also underwrites an ILS issue has become a de facto player with ‘skin in the game’. That kind of direct involvement in ILS at best may distract the service provider from the service task; at worst, it can disturb the service provider’s priorities. That’s why a service provider’s independence is such an important quality.

Making a choice

The explosive growth rate of ILS since their inception is a testament to the ability of insurance and capital markets to evolve and adapt to new market opportunities. To foster the continued health and robustness of the ILS market, participants should pay close attention when selecting the service provider that will administer an ILS financing—for instance, the service provider’s ability to offer independence, comprehensive expertise across a range of required functions, longstanding reputation and commitment, and reliable financial soundness.

Service providers that possess some combination of these requirements, but not all, do not get a passing grade—a provider that may have the operations but not the legal capabilities, or that may have the experience but keeps ‘skin in the game’ through its underwriting does not pass muster. Rather, to get it right, the provider institution should possess and be able to offer all the qualifications; anything less and it risks falling short in realising the full value of your ILS financing at such a crucial time in the market’s explosive story.

Alex Tsarnas is head of US corporate and insurance sales and relationship management at BNY Mellon Corporate Trust. He can be contacted at:

Erin Courcey is business group manager—US corporate and insurance at BNY Mellon Corporate Trust. She can be contacted at: