No Immediate Brexit Hit To ILS Market, But Structural Issues To Consider

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Includes: GLRE, HVRRF, HVRRY, SSREF, SSREY, TPRE
by: Steve Evans

So, overnight the United Kingdom population has voted in favor of leaving the European Union, in what is to many a surprising result that presents a number of potential issues for the insurance-linked securities (ILS) market to consider.

Clearly, the ILS market is an international business, with both the end investors in the sector and the assets (or reinsurance contracts invested in) sourced on a global basis. The managers of ILS investment funds and strategies are domiciled in a variety of locations and their investment vehicles are often not domiciled where the ILS managers main base is.

For a global industry whose work involves international capital flowing across borders and business sourced from markets around the world, any major political upheaval has the potential for ramifications.

It's very hard at this stage to say what issues an insurance-linked securities (ILS) fund manager may face, or for that matter whether the new status-quo that emerges post-Brexit might offer opportunities for some.

Location and domicile will obviously be relevant to whether any Brexit related issues affect ILS managers or ILS investors, with access to the EU or access to the UK the obvious potential areas of concern.

But to begin, it's important to note that right now things will remain as they are and even after Article 50 is invoked and the wheels are put into motion by the UK government to leave the EU it could be some time before any impact would be felt.

Perhaps first the biggest threat, to insurance and reinsurance as well as ILS, could be companies leaving the UK, a drain of talent, counterparties becoming more remote (in terms of location) and also any punitive action taken by the remaining EU countries who may be displeased with the decision of the UK.

With other reinsurance markets growing in importance, London does face some uncertainty right now. While the London insurance and reinsurance market is certain to remain a world leading hub, there will without doubt be some ramifications.

Any ramifications for the insurance and reinsurance industry will have the potential to affect the ILS market, given the convergence that has occurred in the last decade. And of course a period of uncertainty can affect confidence, which can result in negative impacts to any financial sector, from which ILS will not be totally immune.

Reinsurance firm Munich Re came out this morning with a statement saying that the UK could lose influence in the world, compared to other financial hubs. That's a real possibility, particularly if the transition from in the EU to out turns messy and divisive.

Meanwhile Lloyd's of London Chairman John Nelson said that Lloyd's is prepared, has a contingency plan and will be fine. But, of course the Lloyd's market will not be completely immune and will feel any wider market pain that hits the UK, simply due to its location.

For insurers and reinsurers from abroad with bases in the UK and London, the options around domiciles will have been considered months ago, in order to create contingency plans. In the coming months we will likely find out whether any of those plans included leaving the UK altogether.

For ILS investment managers directly, issues around passporting to access investors in the EU need considering by those in the UK, or for those outside of Europe that have used passporting rules to access UK investors there could be a requirement for some structural change.

ILS fund managers located in the UK will need to consider arrangements under MiFID or AIFMD, around the ability to sell on an unrestricted basis into the EU.

Equally, ILS fund managers located elsewhere, either using the UK as a passporting stepping stone (rare) or who use Europe as a stepping stone for passporting to distribute into the UK to target investors, will need to consider carefully what this will mean and may need to make some structural change to maintain efficiency of operations in a post-Brexit world.

ILS fund managers in the UK and Europe will likely operate their co-mingled ILS investment funds under AIFMD (Alternative Investment Fund Management Directive), while MiFID (Market in Financial Instruments Directive) will be used for any managed accounts for single investors.

The importance of continuity will be key, with the need to demonstrate the equivalence, in governance, structure, regulatory compliance and protection, vital and this could mean some changes in structure for some managers in the future.

Of course any major political or financial market upheaval could result in the need for changes to structure and even to where funds are ultimately domiciled, in any investment market including ILS.

Advisors Eversheds explained that some investment managers relying on passports under EU related directives such as the Capital Requirements Directive, Market in Financial Instruments Directive (MiFID), UCITS Directive, Alternative Investment Fund Managers Directive (AIFMD) and Solvency II Directive, may have to restructure their businesses. Important to remember that there is time for any affected ILS managers to arrange a restructure.

Those ILS managers already operating successfully under AIFMD or MiFID have sought equivalence and approval before, and for those in the UK whilst in the EU, so this is unlikely to change as long as the structure of the manager or fund still supports this.

Artemis spoke with Luca Albertini, CEO of London based insurance linked securities investment manager Leadenhall Capital Partners LLP, about the potential for ILS market ramifications.

Albertini explained; "If logic cooperation and peace prevails therefore I would see little implications and we would be like Swiss managers with a strong equivalent regime allowing us to roam around the EU."

That is the end-result that the UK based investment management community will be hoping for, ILS managers included.

So while there is the potential for structural ramifications for the ILS market due to Brexit, there should be time to resolve them and for ILS managers located in the UK the impact should not be meaningful.

More of a threat could be general financial market volatility, which can of course affect investor allocations and just generally cause uncertainty that can be negative for many investment markets.

But, where ILS shows its strength at times like this is in the lack of correlation its returns have to wider financial markets.

With share prices and currencies plummeting today, the ILS fund market returns will likely be largely unaffected (currency moves could see some minimal fluctuation in some valuations) and will once again demonstrate its benefits to investors, as an asset class offering attractive returns that does not move in tandem with the rest of the financial markets.

Of course it's difficult, if not impossible, to predict how this will shake out and how it could affect reinsurance and ILS. We're in uncharted territory and these are just a few of the initial thoughts we have about potential ramifications and issues to consider. No doubt this will become clearer with time.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.