ILS: Down the road towards securing ratings

Even the most cocksure rebellious teenagers can grow up to become respected members of the community; even the most rabblerousing activists often join mainstream politics and become part of the establishment; even the most innovative entrepreneurs can end up running companies that bear little resemblance to the quirky, alternative startups that once defined and led to their success.

Pick your metaphor as you will—the concept of the upstart becoming the usurper and then the establishment is a common transition that can be found in many aspects of life and business.

Reinsurance has seen many versions of this evolution. Bermuda has witnessed many waves of startup reinsurers—all lean, nimble and offering an ‘alternative’ solution when first launched. They are now the establishment. The same can be seen in Lloyd’s of London, and in the managing general agent and broking worlds.

There are times when this transition happens so fast and so brazenly that even the most seasoned commentators are surprised. That could be the case in relation to the rapid movement of insurance-linked securities (ILS) funds and writers of collateralised reinsurance coverage.

They are clearly becoming more mainstream and, not content with writing ever-bigger lines of business and moving into a growing breadth of lines of business, it appears some funds are now on the brink of taking the final step towards respectability—obtaining a rating.

“This is the biggest topic of conversation in London and Bermuda at the moment,” according to one market observer.

“A number of the bigger funds are considering it. The question is, if they all do this, where does that then leave traditional reinsurers? Their advantage has always been their rating—the leverage this allows them and the robust oversight overlying it—which many buyers like and will pay for. If the ILS players are rated, every piece of the market and piece of business is suddenly up for grabs.”

Paving the way

This phenomenon is not exactly new. The first fund to secure a rating was the one managed by LGT ILS Partners, the insurance and reinsurance-linked securities investments unit of the private bank and asset manager. Originally called Collateralised Re, the unit was renamed Lumen Re when it upgraded its licence to a class 3A and secured a financial strength rating of ‘A’ from AM Best in December 2017.

LGT ILS Partners said that, despite having a rating, it would continue to trade in fully collateralised paper. But it stressed other advantages and reasons for securing the rating. It noted that as collateral can be held centrally by the rated reinsurer, Lumen Re, it makes collateralised reinsurance simpler, as it removes the requirement for a separate collateral solution for each cedant or transaction, reducing some of the complexity.

It also noted that having a rated reinsurance company will serve to enhance its access to underwriting business, given some cedants may only be able to utilise a rated reinsurer, especially in some foreign markets. It also said that the rating would allow LGT to expand the reach of its collateralised reinsurance products, bringing in a broader spread of the underwriting market to the benefit of its ILS funds and their investors.

Specialists in this field in Bermuda—the domicile of most ILS funds—argue that the path taken by Lumen Re is a natural one. Although securing a rating may become the reserve of only the biggest funds—maybe only six or seven globally are big enough to truly benefit—they see a clear logic and advantages to doing so.

Brad Adderley, partner in the corporate department at Bermuda law firm Appleby, explains that the most obvious logic for doing this, as Lumen indicated, stems from the spiralling administration costs for these funds as they do more and more deals. He estimates that the bigger funds will be completing approximately 100 transactions per year. Each of these will require a separate trust being formed to hold the collateral, each with associated administration costs.

“The burden of the administration costs must be a nightmare for those bigger funds,” Adderley says.

“It will be very time-consuming and increasingly expensive. Getting a rating also has a cost associated with it and is a time-consuming process. But you have to weigh up the pros and cons of both options—if the costs are even roughly the same, having a rating can bring many other benefits.”

Will the additional regulatory burden be a problem for funds taking this step? He thinks not.

“Most are already complying with high regulatory standards and although this adds an extra layer I don’t think it will be a big problem for them,” he says. “Maybe they will need a few more staff based in Bermuda, but most have some good people here anyway.”

Adderley stresses the flexibility and options a rating can give a company—it may well continue to write business on a purely collateralised basis but without the administrative burden of having to form multiple trusts. But it also gives the carrier the option of considering offering business written purely off the balance sheet if that’s what cedants want—or even a mixture of both.

“It puts a reinsurer in a much better position,” Adderley says. “The first step is probably to get your clients to have faith in your business model to the extent that you continue to write collateralised business but you simply hold the funds on the balance sheet.

“Then you might consider doing something clever around the way reinstatements work—perhaps the reinstatement could be written on a traditional basis off the balance sheet on a non-collateralised basis. That gets around problems such as trapped capital; it offers the best of both worlds.”

One market observer describes this process as an inevitable evolution for the market. He notes that, as with any new market, over time more competition has moved in and the margins have become thinner. As a consequence, carriers will look for ways to set themselves apart and give themselves more flexibility to write different types of business and enter new markets.

The final step

It is then only a small step, Adderley admits, to funds writing traditional business on a regular basis. It is also very possible, he notes, that some of the bigger funds could secure ratings higher than many of the traditional players they are competing with.

“They have the track record and the capital behind them—suddenly there is little to set them apart,” he says.

“It is an interesting phenomenon and sort of ironic. But it could be a game-changer for the market in the sense there will be no longer be any barriers, and no lines in the sand between the funds and the traditional carriers.”

On the face of it, it appears that this process would see the funds move into a space already occupied by many traditional players that have given themselves the ability to tap into the capital markets via sidecars and other vehicles. In a sense, the funds have now arrived at the same point, giving themselves the flexibility to write business in different ways. They have just arrived at that point from the opposite direction.

Although broadly true, in fact, there will be some differences, crucially in terms of who the different carriers are ultimately accountable to.

One market observer explains that whereas traditional carriers are ultimately accountable to their shareholders, the funds are accountable to their investors. While the distinction may seem a subtle one, it becomes important when the nature of a sidecar formed by a traditional player is considered—the needs of the investors in that sidecar must inevitably come after those of its ultimate shareholders.

In the case of a fund, the investors are the only priority. The fund lives and dies by the return and level of service it can offer those investors. However, it is not necessarily a case of one being better than another. Having long-term equity shareholders can also be a benefit should a company need to replenish capital quickly in the aftermath of a big loss; the sentiment of investors towards the sector in such a scenario remains more of an unknown.

“It is an interesting dynamic that some investors will consider,” says the market observer. “The traditional carriers would argue that their investors are very sophisticated and, in fact, there is an alignment of interests. But there is clearly a conceptual difference.

“The rating agencies will also take into account the ownership structure and how easy it might be to raise additional money. Everyone will have their own view on that.”

It will also be interesting to see how cedants view the creditworthiness of funds that secure a rating. They will understand they are buying a very different type of security if they are working with funds on a traditional basis. When buying collateralised coverage, they were assessing the strength of a financial structure; now, they will be assessing (with the help of a rating) the strength of a balance sheet and a company’s ability to execute a business plan.

One market observer notes: “The ability of that company to remain profitable, the skills of its management team, its position in the market—all these suddenly come into play for cedants. They did not need to consider these factors when placing collateralised business.

“Yes, a rating helps give reassurance but most cedants also do their own due diligence; some may welcome the extra flexibility and choice, others may prefer to continue to trade on a collateralised basis as they have always done.”

Either way, the fact is it will mean more competition in an already crowded market and more choice for cedants, who are already in the driving seat when it comes to negotiations. This could mean a game-changer for the market—or equally it could just be the continuation of a longer trend played out over many years.

“It is being talked about a lot and it is flavour of the month, but then the reinsurance markets can have something of a herd mentality,” says the observer. “I see it as a natural evolution similar to a process we have seen in many areas of the capital markets where things develop towards more efficient structures offering more flexibility and choice. The real question—the elephant in the room—is simply what cedants want, and how many want rated paper.

“That will inform much of how this will play out and the lines of competition going forward.”