As the ILS sector continues to grow and mature, concerns have been raised as to whether the development of governance and infrastructure in the sector is as robust as it should be,
Insurance-linked securities (ILS) funds have experienced rapidgrowth in recent years. While the frequent and severe naturalcatastrophe events of 2017 took the nascent industry into unchartedterritory, concern about investors’ commitment to the space in thewake of the resulting heavy losses has largely been put to rest.
Investors have stayed the course: despite significant trapped capital, fundswere largely able to reload capacity for the January 1 and subsequentrenewals in 2018.
Other concerns have emerged, however, about whether the developmentof governance and infrastructure at ILS funds has kept pace with thegrowth in assets under management, or perhaps more importantly withpractice in the broader funds industry. The uncertainty brought about bythe 2017 events tested governance frameworks and in some cases raisedconcerns on the part of investors about independence of process.
In some structures fund managers rely, to some extent, on their affiliatedreinsurers’ staff to perform key steps in the valuation process. In such casesinvestors may raise concern about the potential lack of independencewhen there is a perception that key decisions impacting the net asset value(NAV) are being made by affiliated reinsurer management or staff.
The 2017 year clearly demonstrates that losses can be difficult to evaluate,and people will inevitably get it wrong. This has certainly been a cruciallearning phase for investors and the ILS industry, and in certain instances,fund managers or capital providers have begun to express a preferencefor independent inputs to the valuation process outside of ILS managers.Indeed, we believe managers themselves will prefer not to be the only partiespreparing the inputs before the NAV is struck. Demand has also emergedfor real-time information about not just named storms but also attritionalcatastrophes that may be independently corroborated by a third party.
Independence in this instance is more than simply an academic concern;there are practical consequences. Estimates of the ultimate cost of a naturalcatastrophe are subject to a high degree of initial uncertainty, which impliesthat there is a wide range within which to select a reasonable estimate. Healthyreinsurers may have an incentive to select a reserve at a high percentile of thereserve distribution in order to reduce the likelihood of a later reserve chargebecause the penalties they face for inaccuracy are asymmetric.
Troubled reinsurers may have an incentive to select a reserve at the lowend of the reasonable range in order to preserve sufficient capital to tradeforward. ILS funds, on the other hand, may prefer to set NAV based on a distributional central estimate such as the mean or even the median of theunpaid loss distribution, preferring to operate based on the highest levelof accuracy given the available information.
In addition to estimating the loss liabilities, the valuation process involvesdetermining the portion of the contract revenue that is earned as of thevaluation date. There is a range of earnings patterns that may be applied toa given contract covering property cat events. Investors may be concernedthat the selected earnings pattern is misrepresenting their interest, andthus an independent input may be preferred.
Another component of the valuation is the risk margin. The risk marginis to reflect the additional premium a third party would be required tobe paid in an arm’s length transaction to assume the insurance liability inorder to reflect the inherent uncertainty in the transaction.
Current practice for determining and including risk margins in the valuationvaries considerably. Risk margins reflect uncertainty, and the level ofuncertainty surrounding the loss outcome from cat events varies greatly by event, as well as of course with the passage of time from the event. We expectthat this aspect of the valuation process will get refined considerably overtime. This is another area where it is valuable to use an independent party whois familiar with emerging practice and techniques for deriving risk margins.
The evolving result for the ILS fund industry is an emerging practice ofconducting independent valuations, and funds which had been conductingsuch valuations in some cases are considering increasing their frequency.
Fund managers at the same time are fine-tuning their governance processesand instituting valuation policies to introduce more structure in their reportingcycle for the prior month end NAV. This includes specifying dates anddeliverables as well as ownership. Necessary protocols are developed for issuessuch as national holidays within the reporting window, as well as dealing withthe treatment of late-arriving new information based on materiality criteria.
Funds must respond to the shifting regulatory landscape. The fundindustry must cope with an overlap of fund regulation with insuranceregulation and it requires a unique overlap of fund expertise withreinsurance expertise. There is a real potential for regulators to adapt byimplementing new reporting requirements in response to market growthand lessons learned from the 2017 cat events.
In the first half of 2018, ILS funds have continued to grow and attractincreasing amounts of capital, so their focus is of course on deployingthat capital effectively on behalf of their investors. However, in manyother asset classes, investors will not invest in funds where there is noindependent valuation agent or at least real independence in the processof calculating the NAV. As the ILS asset class matures, with difficult-tovalueevents, it seems likely investors in these funds will require moreindependence in the valuation process. Ultimately, investors will decide.
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