The collateralized reinsurance market has been the fastest growing sub-sector of the insurance-linked securities space, as ILS funds and managers have increasingly participated in traditional reinsurance contracts on a fully collateralized basis.
As investors increasingly sought to access catastrophe-focused reinsurance risk as an investment asset, the collateralized reinsurance market has become the biggest supplier.
However, the potential for collateral lockup on these contracts may mean that investors do not achieve expected returns - an exposure that could become more prevalent as the market expands.
Collateralized reinsurance placements typically cover a one-year risk period, releasing collateral once the contract is completed; however, the fully-collateralized nature of the contracts ensures that investor capital is locked within the contract until any losses on the contract have been fully settled.
This has the potential to result in investor collateral being tied up after the actual contract end date as it takes time to settle claims after a loss, causing a 'drag' on investor earnings that isn't frequently quantified in the ILS market, according to a new whitepaper that explores the issue.
As noted in the Milliman Whitepaper, 'Measuring the Impact of "Locked Collateral" on Collateralized Reinsurance Returns,' the issue of locked collateral is often minimal, as the majority of collateralized reinsurance arrangements relate to short-tail business lines that rarely experience a loss, so there's often little or no collateral lockup.
"Nevertheless, losses do occur over the long run, particularly because ILS managers are increasingly writing deals that suffer frequent losses (such as whole account quota shares).
As a result, using a contract-length return horizon (i.e., a one-year period for most deals) in the pricing process will tend to overstate the actual long-run returns. Instead, a multi-year return model is needed," says Milliman.
Capital markets investors that participate in the ILS market have become increasingly sophisticated and mature alongside the growth of the market.
The increased focus on collateralized reinsurance placements as a result of investors seeking additional diversification and yields, suggests more ILS players could be exposed to frequency events, with the range of peril exposure growing also.
As a result, there could be potential for increased collateral lockup as ILS funds' exposures grow, underlining a need for investors and managers in the space to understand the potential risks.
The whitepaper proposes that a multi-year view for collateralized reinsurance placements would provide a more realistic estimate of the long-run expected return.
Milliman proposes using a Time-Adjusted Return (TAR) model to achieve this, which is "based on an internal rate of return (IRR) framework coupled with actuarial loss development patterns."
The model takes into account the frequency of loss payments, severity of loss payments, and the timing of loss payments, explains Milliman.
Then applying the model to both a catastrophe excess-of-loss contract and a whole-account quota share contract, the whitepaper shows that the estimated annual average return for the investor is lower than under a single-year model, highlighting the 'drag' on returns as a result of locked collateral.
Under the TAR model, Milliman shows via a case study that the annual average return after accounting for collateral drag for an investor within a catastrophe excess-of-loss contract is 4.91%, compared with a hypothetical return of 6% under a single-year model.
For a whole-account quota share, the decline in estimated annual average return is even steeper, dipping from a hypothetical 10% expected return for a single-year model to 7.96% with the TAR model, further highlighting the potential for a greater 'drag' on earnings owing to ILS investors increasing exposure to frequency events.
In order for the ILS market to continue down its impressive growth path, it's vital those that participate in the space understand the risks just as they do the benefits. Milliman actuary Aaron Koch told Artemis that the locked collateral phenomenon was just one of many new considerations that funds face as they continue to grow and diversify their portfolios.
"Collateralized reinsurance can often bring a broader range of pricing and valuation challenges to the table than a traditional catastrophe bond," he said.
"This additional complexity is the trade-off for the diversification and yield opportunities that collateralized reinsurance can offer. In the end, the growth of collateralized reinsurance provides an opportunity for funds to differentiate themselves by their underwriting expertise and understanding of topics like locked collateral."
Collateral lockup could become an increasing issue for the space as ILS funds operate on larger, and longer-tailed business lines that have greater potential to suffer multiple and larger losses, so it's important the risks are adequately accounted for in expected returns.
The decline in expected annual returns under both case studies in the whitepaper is significant, and should collateral lockup become an increasingly prevalent exposure within the collateralized reinsurance landscape, it's possible different approaches to modelling will be a feature.
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