The risk of trapped collateral has long been a known feature embedded into cat bonds and other ILS structures. It is a real, though often unpriced, impediment to returns. Sponsors have held back billions of dollars on expired transactions because of potential exposure to known loss events. Such risk can, however, manifest even in short-tailed lines. Almost three years after Hurricane Irma, the “loss creep” is still significant.
In 2020, ILS contracts face new unpriced risks of trapped collateral: litigation around business interruption claims on commercial property insurance policies and legislation and regulatory actions in many states that have the effect of tolling statutes of limitations for filing claims as long as the emergency declarations caused by the pandemic remain in effect. If, as predicted, 2020 brings major hurricanes to the US, investors will see large amounts of capital trapped at the end of the year, potentially even more than the $20 billion experienced at the end of 2017.
In the past, investors had limited options to address trapped collateral issues following an event. Holders of 144A cat bonds could request dealer quotes, but a limited number of dealers, a thin secondary market, and wide bid/ask spreads often combined to make these quotes unattractive. Investors in private ILS had even fewer options short of asking a sponsor or fronting reinsurer to provide a commutation -- equivalent to seeking to trade with only one potential bidder.
A liquid market place--such as exists for swaps--changes long-term risk of adverse development into short-term risk of price fluctuation. In an active market, capital is not trapped. In an active market, capital is always finding its best use. Now, this can be done for insurance liabilities.
Extraordinary Re has built a unique and innovative platform combining the best features of a traditional reinsurer, transformer vehicle and a trading exchange. With an account at Extraordinary Re, ILS investors can deploy their capital with greater precision, timing, granularity and flexibility. Investors can select specific contracts, or even segments of contracts, to add to their portfolios. And investors can engage in secondary trading to manage their portfolios, including the ability to sell and cleanly exit any risk position using a familiar bid-matching protocol.
The time to address the risk of trapped collateral is at contract inception, not following a loss. Investors with the foresight to access insurance risk through Extraordinary Re will reap benefits to their portfolios through added investment flexibility, enhanced transparency and price discovery, and will reduce the exposure to trapped collateral.
The current reinsurance market offers more attractive pricing, terms and conditions than have been seen in years. Astute, long-term investors will also seize the opportunity to achieve permanent structural improvements in the ILS market. Such improvements are a hallmark of successful financial innovation, which has been missing from the insurance market until recently.
Extraordinary Re is ready to launch operations and become a new focal point for the ILS market. We welcome the participation of investors who share our vision and are ready to capitalize on this moment. Carpe diem!