The importance of valuation standards in ILS
Two years of significant loss events, many of which have experienced significant loss deterioration, have exposed some limitations and areas of improvement of the ILS fund management industry. This should be expected of an industry whose core product hadn’t been tested through to the end of its lifecycle for several years, due to a series of benign cat years. The key lies in how the industry responds to these challenges, and determining how issues can be mitigated in the future to support the (still nascent) insurance securitisation process.
One big area of concern is how ILS funds value and report their positions on loss hit portfolios. There are two reasons why this is a particularly acute issue for ILS funds. Firstly, coming up with a timely, accurate valuation of a loss event is arguably of more fundamental importance to ILS funds than traditional reinsurers. Traditional reinsurance equity/bond investors assume all the various risks of the company (including any prior year reserve development, asset management performance and any operational ‘noise’). A key attraction of ILS investing however is assuming exclusively the pure insurance risk spread for the timeframe between subscribing and redeeming. This makes it critical to get a speedy, accurate value of a loss in order to sidepocket a position for redemptions.
The second reason is that ILS funds are lean operations, run with limited resources and potentially with back office functions and systems playing ‘catch up’ to the remarkable growth many funds have achieved. Given the most likely result of a catastrophe bond is ‘no loss’, the number of loss events over the last two years may have created a resourcing squeeze in the actuarial, claims and investor relations teams of some funds.
The issue can be demonstrated by the relative contribution to 2018 results of prior year events of ILS funds and traditional reinsurers. Through 2018, the ILS fund industry experienced considerable reserve deterioration, principally on losses relating to hurricanes Harvey, Irma and Maria. However, a number of the largest traditional reinsurers’ results either benefited from prior year P&C reserve releases, or experienced no impact. There are caveats here; traditional reinsurers have a broader array of risks in their reserves and are able to apply a degree of prudence to their reserving (a luxury that ILS funds can not enjoy as it would detriment early redeemers). Nonetheless, the extent of loss creep has contributed to ILS investors becoming increasingly discerning around fund selection, and to the Standards Board for Alternative Investments (“SBAI”) publishing a set of standards around valuation governance. Signatories to the standards include some of the largest funds and institutional investors in the market, including Nephila, Hiscox, PIMCO and most recently Leadenhall.
Putting in place a robust framework around valuation and reporting should be a priority for ILS funds. Any framework should include appropriate management of conflicts of interest and ensure independence and consistency of valuation processes. It is a topic that is attracting regulatory interest, most notably with the Bermuda Monetary Authority and US Securities and Exchange Commission launching inquiries in to loss reserving practices at CATCo. Moreover, being able to demonstrate a robust framework can act as a differentiator for fund managers, building trust with investors and ultimately working to grow the ILS fund industry as a whole.
For all its remarkable growth, ILS fund management is still referred to as ‘alternative’ capital. Building robust governance standards can reinforce the perception that third party capital has a long term and valuable role to play in the (re)insurance industry.