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Black swan losses require alignment on ILS collateral solutions: Panel

Hamilton, Bermuda, City View

Insured events for which loss quanta are highly uncertain for extended periods of time require collaboration and ‘adult conversations’ between investors, ILS managers and cedants to manage, according to a group of experts.

Speaking on a panel as part of Trading Risk’s ILS Week event, Pillar CEO Steve Velotti highlighted the challenge presented by the ongoing pandemic, noting that “nobody had a Covid model”.

In many cases, Velotti said, ultimate losses are unknown, creating valuation difficulties for a fund manager.

“How do you roll [existing] collateral forward [in order to cover potential Covid claims] when you have new investors coming in for the following year, and then tell them, ‘I know that the valuation of the fund is exactly correct’? that’s a tough promise to make,” he said.

“In instances like that, you need to either create a side pocket to wall off the new investor, or prevent the existing investor from redeeming and leaving without paying their due of claims,” Velotti said, adding that Pillar created a new share class in order to distinguish between groups of investors.

However, he also pointed out that ILS capital was not designed to provide ongoing cover for events with long-tail risk.

Dan Brookman, CEO of Gildenbrook, said that mechanisms that allowed collateral to roll over from one year to the next in such uncertain situations help because such arrangements “align interests between investor and insurer or reinsurer”.

“Generally speaking, they’re in the same boat on that uncertainty,” he added.

Steve Britton, managing director, global ILS management at Aon, added that on some of the sidecars he manages, he witnessed cedants, arrangers and investors align their interests on rollover and “have adult conversations on how to solve this problem”.

Some ILS funds have also been strengthening their language around collateral release in response to the Covid-19 losses, Britton noted.

Funds have, for example, looked to bring collateralised reinsurance agreements more into line with terms of cat bonds in which cedants must elect quarterly to extend capital after maturity and, in some cases, pay an additional premium to extend.

This comes after some cedants last year swerved the typical buffer loss table calculations used to determine capital that can be held and locked collateral on the basis the pandemic was an ongoing event.

Separately, Britton said that Aon is in discussions with traditional reinsurers, legacy carriers and ILS funds about loss portfolio transfers and adverse development cover risk transfer solutions.

“The legacy markets are looking at this as a diversification from their normal business that they buy. Success just comes down to price and having really good loss development data,” he said.

Brookman, meanwhile, said the ideal scenario for dealing with trapped capital would be a clearing house or other marketplace solution.

“What you see across the broader capital markets is a tendency for clearing mechanisms or marketplaces to emerge to handle assets when they trade distressed or broken,” he said.

“That would be the ideal: to be able to have liquid markets that are able to observe, assess and price risk and give investors choice on whether they want to exercise that liquidity or not. The natural repositories for this could be run-off funds.”

However, Brookman added that the relatively long tail of property cat losses would not align with the longer-dated liabilities that run-off agents focus on.

Velotti said that Pillar had dealt with some distressed investment specialists who were willing to buy investors out of trapped positions, but noted that many investors preferred to wait out the development phase of a loss rather than pay to exit.

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