Collateral can be held too long for US wind ILW’s, study suggests

With the key January reinsurance renewals having been challenging and characterised by reduced capacity and higher pricing, the focus can often turn to buying hedges such as industry-loss warranties (ILW’s), but a new study highlights some issues investors should be aware of.

The study by Kriesch Advisors, mandated by Swiss-headquartered capital markets risk transfer focused fintech Cerchia, looks at the industry-loss warranty (ILW) product, by analysing PCS loss event data and finds that in some cases the collateral applied to an ILW contract may be held for longer than perhaps warranted.

After the main January renewals, the reinsurance and retrocession market typically has a focus on hedging or filling gaps in coverage.

This can also involve a focus on reducing retentions, ahead of the forthcoming Japan and US renewal seasons, the study explains.

Kriesch Advisors, operated by well-known ILS industry executive Sandro Kriesch, states that, “The shortage of available UNL capacity places the current focus for buyers firmly in the ILW market, however, while ILW pricing and attachment has improved dramatically, investors have long been concerned by the potential for collateral to be trapped by losses that will not threaten the loss warranty trigger.

“Unless an agreement can be made with the buyer to redeploy the capacity, investors face the damaging prospect of diminished returns, increased management expenses and an inability to re-deploy the collateral.”

Having analysed 25 years of PCS data featuring 72 US named storms that PCS has reported losses for between 1998 and 2022 (excluding hurricane Ian), the study concludes that concerns over collateral, when it comes to ILW contracts, “do not appear to be unfounded.”

The study found, inter alia, that:

It took an average duration of 6.1 months from the initial PCS estimate to the announcement of a final estimate.
The PCS loss amount increased on average 20.4% from initial to final estimate.
For the 25 storms where PCS provided reports over at least 6 months, the average development in the last 6 months was only 8.3%
For the 17 storms where PCS provided reports over at least 12 months, the average development in the last 12 months was only 10.5%.

The study authors at Kriesch Advisors state that, based on the data analysed, “There appears to be very little alignment between the construction of collateral release clauses and the actual reporting development of losses, possibly due to the evolution of such clauses being based on UNL loss development patterns rather than actual reporting developments.”

They believe there is a misalignment of interests, between the ILW buyer and the sellers of protection, evident in this data.

This boils down to the ability of an ILW protection buyer being able to, “hold collateral hostage in order to negotiate improved renewal terms or wait as long as possible before returning funds to investors,” the study author’s state.

Going on to explain, “Why is this important? – an ILW contract with a $50bn trigger for US Wind could potentially have capital trapped for 6 months or more by a $20bn loss that has little or no prospect of triggering the contract.”

The data suggests that PCS gets close to its final loss estimates after the first two reports are issued and there are no cases where a larger event, greater than a $20 billion industry loss, has developed more than 55% from its initial report (even hurricane Irma only developed 52%).

“The reality is that the lack of the alignment hurts both buyer and seller in this scenario, through the increased cost of capital associated with the potential of trapped losses and the consequential increased prices,” the authors highlight.

Saying that, “It also inhibits the prospect of additional or new capacity entering the market, again impacting pricing.”

Kriesch Advisors is working with Cerchia and reinsurance consultant Allemond Ltd. to develop what they see as a new approach, that can support a better alignment on ILW trading.

The group aim to “break the dogma associated with ILW contracts and introduce mechanisms that align the interests of the parties,” believing that this will help to increase the efficiency of the market, helping ILS managers to attract capital to the market, which is clearly needed at this time.

Speaking with Artemis, Sandro Kriesch said, “Holding on to collateral when it does not make sense is a big loss of efficiency for the market, one that drives capacity away!

“I believe 2023 is a good moment to consider weaknesses and act upon it – for the benefit of all parties.”

Kriesch continued to explain, “We are working to redesign the release schedule and align the collateral clauses to the loss reporting history, to encourage closer collaboration between buyer and seller after ILW contract inception.”

Alan Groves, of Allemond Ltd. added, “As loss warranty attachments increase, so the spread to the point at which collateral can be trapped widens.

“The time is right to challenge established practices through the creation of a new balanced and aligned product structure that will attract capacity.”

Michael Rey, CEO of Cerchia said, “Ultimately, we want to help establish a more resilient industry by closing protection gaps.

“By focussing on ILWs in a first step we build bridges to capacity which has so far not participated in the reinsurance industry.”