A Wolf in Sheep's Clothing

Today investors in certain ILS structures are cosily told about the risks that they will assume – non-correlated to the capital markets, well selected, well modelled and part of a well-diversified portfolio. Whereas it is doubtlessly explained that events can and periodically do occur, investors see from recent years that this is infrequent and the returns appear good. (Re)Insurers and fund managers will explain how they are able to source the best risk-return investments for the best-performing portfolios and how they always have the best interests of the investor at heart. The question today remains how true are all these comforting, woolly statements? Are investors really getting the risk-return they bargained for? Or are (re)insurers really the wolf, taking advantage of some investors' naivety and desire for return to raise negatively priced capital for their balance sheets? Hidden behind complex structures, it appears that investors are increasingly not aware of the risks they are assuming nor the cost to them of assuming those risks. This paper attempts to highlight some of the issues within various structures in order to allow investors to more fully understand the risks that they are assuming with these structures and to provide them the necessary background for performing the required due diligence prior to selecting the (for them) appropriate ILS investment structure.

Direct Cat Bond Investing

Investing directly into Cat Bonds, or into Cat Bonds through a fund, typically has no hidden risks. Only in recent years has a new structure been designed which injects credit risk and therefore econometric risk into the few investment instruments in which it is used. As of today this exists only in two bond programmes – the Alamo and Cranberry Cat Bonds. The danger of the structure itself was more fully explained in Solidum's July 2015 paper “Are ILS investors repeating the mistake of 'Lehman'?”. In this example it would be incorrect to say that the additional risk, i.e. that noteholders are fully exposed to Hannover Re credit risk, is hidden, it is not. It appears in the risk factors, although it may be difficult for investors to fully grasp how this risk described in the risk factors actually comes about.

The result of the structure has two primary effects, one on the investors and one on Hannover Re. Some ILS funds / investors may be ignoring, and therefore not pricing for, the credit risk of Hannover Re that they are assuming. The effect on those funds / investors may therefore be twofold: (i) their actual return for a given $ of risk may be less than they expect; and (ii) their investment may not be as diverse to their other capital markets risks as they anticipated.

The effect of the structure on Hannover Re is rather attractive to it. Hannover Re is providing a service for which one assumes it is remunerated (although maybe it provides the service for free), but as a result of the service it gets a capital infusion for a fixed 3 years (absent a loss) – currently, as at 28 April 2016 Hannover Re debt yields 1.75% (based on the Bid and until next call date in 2020 with the assumption that it will then be called). Given that the total issued amount of the Alamo and Cranberry Cat Bonds is $1.4bn, Hannover Re is getting capital to finance its business, currently worth an annual $24.5m, for free, or is even being paid to accept it! To the extent that this is great business for Hannover Re, conversely someone is leaving money, and a lot of it, on the table; this can only be the ILS funds / investors who have invested in these Cat Bonds.

Investing into (re)insurer-managed funds

In recent years reinsurers, and to a lesser extent insurers, have been entering the ILS market. The various entities have entered the market in different ways. Certain entities have begun funds 'at arms length' and exert no control over the fund management, provide no business into the fund and do not provide fronting or other services. These funds have no hidden risks or no conflicts of interests. Other (re)insurers have set up funds to act as a vehicle to provide them with reinsurance/retrocession on a collateralised basis. The (re)insurance company (parent) controls the risks assumed by the fund on behalf of its investors. It is taking risk away from its equity-holders and, for a price it decides, moves this to its fund investors. This clearly raises a conflict of interest. How can an entity sit on both sides of an 'arms length' transaction? If the transaction is good for the equity it is bad for the fund investors and vice versa. Who does the management of the (re)insurer owe a duty of care to in such a conflict? The equity or the fund investors? A further issue that investors should be aware of is that in certain of these instances the fund assets may be, in the same way as with Alamo and Cranberry, drawn by the parent (re)insurer to assume the reinsurance. To quote the website of one entity “[the fund] is fronted and backed by the strong credit rating of [the parent]” - why would the fund be backed by a credit rating and not its own assets unless those assets were being transferred to the parent entity and repayment was then dependent on the parent's credit rating? The website goes on to state that the fund further benefits by “removing the need for inefficient collateral structures associated with direct ILS capital” This statement merits further examination: Collateral within collateralised ILS structures is there for 2 beneficiaries: (i) with a first lien to the (re)insured to settle any valid claims; and (ii) with a second lien to the fund / investors to repay the collateral once the (re)insurance contract expires without loss. Removing this structure removes point (ii) above and increases the risks that the investor assumes, adding other econometric risks to what was supposed to be a diversifying investment sanitised from all econometric drivers. The benefit to the parent (re)insurer is clear, they get a capital injection into their balance sheet much in the same way that they would issue debt. What is more is that the parent is paid to accept the injection of debt rather than needing to pay for it – what could be nicer than to be paid by debtholders to take their money?! As with all (re)insurance capital, this 'hybrid-debt' is leveraged up to write additional premium and, absent losses, make an enhanced return for the equity with negatively-priced finance.

Investing into ILS funds writing fronted collateralised reinsurance.

Investors would imagine that there would be no similar issues when investing in an independent fund – the management of such a fund is independent and clearly owes a duty of care to the investors. Unfortunately, and ever increasingly, funds are writing collateralised reinsurance using fronting entities such as Hannover Re, Tokio Millenium Re, Allianz Risk Transfer and others. In return for a fee these fronting reinsurers will write reinsurance on behalf of the fund and some will even, for an additional fee, provide coverage / leverage at a very remote, e.g. the less-than-1bp, risk level, where it is unlikely to affect the fronting reinsurer's risk capital requirements). In some cases some of these reinsurers, for example Hannover Re and Tokio Millenium Re, will then draw the capital, in a similar way to the Alamo and Cranberry Cat Bonds, to fund their risk. As with the previous examples these assets (i) expose the fund, and through the fund the fund investors, to the direct credit risk of the fronting reinsurer and therefore to econometric risk; (ii) provide the fronting reinsurer debt capital which (a) it is paid to take, and (b) on which it will write additional premium to, absent losses, make an additional return for its equity holders.

Conclusion

Investors in the ILS space are advised to carefully review the use of their invested funds as collateral for collateralised reinsurance structures. They should question whether or not they are taking additional credit risk, which in some cases can be quite considerable, for no additional and commensurate return. Assuming this credit risk clearly ruins the independent risk-return characteristics of pure ILS, one of the main rationales behind investing in ILS in the first place. Assuming unrecognised credit risk of corporate entities may provide an investor with a nasty shock, in the same way that one ILS fund that used Lehman as their prime broker ceased to trade following the Lehman default,

This structure has market-wide implications. For an indication of the scale one only needs to look at Hannover Re's 2015 balance sheet. It shows close to EUR 8.8bn of deposits received from retrocessionaires. Given that the size of the collateralised market is is somewhere around USD 45bn-50bn, Hannover Re is sitting on ca. 15% of the collateralised ILS market, acting in a very similar role to a Prime Broker. Were Hannover Re to fail, like Lehman the damage to the wider market would be considerable and far-reaching – Hannover Re has become a systemic ILS market risk. In the event of failure by Hannover Re, investors may well seek to pull their money out of the sector where they could. Clearly those investors using Hannover Re as fronter (read prime broker) would quickly realize that their assets were blocked by the liquidator to pay future reinsurance claims (reinsurance claims rank more senior than all other liabilities) and that they would not receive them for a long time, if at all. The market as a whole is therefore dependent on a single-name credit risk. As Hannover Re does not front for the 2 largest funds, it would not be unreasonable to believe that as much as 40% of the collateralised market (ca. USD 20bn) could be invested using similar structures, exposing investors and the market as a whole to pure unremunerated credit risk.

Through this structure the ILS market is pushing down its own investment returns. Assuming USD 20bn of capital is invested in this way and the fronting reinsurer uses this capital to leverage its own underwriting – the USD 20bncan be viewed as a capital injection into the reinsurance industry. A reinsurer may easily leverage the capital 4 times i.e. write 4 times the capital as limit. It will do so once for the investors who are writing the collateralised cover and then a further 3 times for itself. Rather than the USD 20bn of capital therefore supporting USD 20bn of underwriting limit, it will support USD 60bn of additional limit. The ILS market is therefore giving huge capital inflows to the reinsurance market to allow the reinsurance market to compete against it.

Through this structure the ILS market is enhancing the equity returns of the reinsurers supporting them, helping them to survive in the current low-premium environment. Again taking Hannover Re as the example, the EUR 8.8bn (a 6.9% increase over the previous year1) of deposits received from retrocessionaires is equal to 110% of its “Equity attributable to shareholders”¹. Given that Hannover Re only has an additional USD 1.5bn of hybrid capital1 , the EUR 8.8bn makes up not far from 50% of the capital supporting underwriting, which was able to generate EUR 17bn of written premium1 (an 18.8% increase1 over the previous year with a falling premium rate). Without the free EUR 8.8bn 'capital injection' Hannover Re's written premium would be considerably lower and it would be forced to ensure that premium rates were sufficiently robust to support their actual cost of capital. Could this be partly why Hannover Re is trading at 1.5 times book value when the reinsurance market is generally trading at 1.25 times book value?

¹From Hannover Re's 2015 Annual Report

Conclusion With Respect to Solidum Managed Funds

When Solidum underwrites and assumes business for its funds it performs an in-depth analysis, not only on the catastrophe risks that form the scope of the business it underwrites, but also on all the structures and any inherent risks therein. Solidum invests the required time and effort to fully understand the motivation and rationale of each entity involved in a cat bond or a collateralised / fronted reinsurance transaction in order to identify the risks in all tail events, even if not directly linked to the covered risks. Solidum is highly aware of the risks that its investors wish it to take and, more importantly, which risks its investors do not expect to be exposed to, even if only arising incidentally. Consequently, Solidum does not favour Cat Bonds with the discussed enhanced credit-risk feature and exerts great care when structuring collateralised reinsurance transactions in order to minimize credit risk and is reluctant to provide a capital infusion, unremunerated or otherwise, to any fronting reinsurer.