“I don’t see this as competing with the traditional players, it is just taking
a different approach to matching capital to risk.” Paul Nealon
Rocking the boat
The company’s alternative approach to the market was again rewarded
in 2018, when it took the unusual and somewhat bold move of acquiring
a major stake in US auto insurer Producers National Corporation, based
in Chicago, which owns five managing general agencies and three
insurance companies. Prior to ILS Capital’s investment, the company was
licensed to write business in eight states. Today the company is licensed
in 12 and expects that number to increase to 17 by the end of the year.
Libassi says the venture came about after a reinsurance broker
introduced the idea in 2017.
“After extensive research and brainstorming, the ILS Capital team
devised a structure that would allow our investors to write this business
via fully collateralised quota share agreements with the insurer covering
certain portfolios of risk,” he explains.
ILS Capital’s investors are behind the equity investment the company
has made in the insurer.
“That means our investors get returns from both equity ownership
in the company and the quota share reinsurance contracts we write—
fully aligning the interests of our investors, Producers National, and
ILS Capital and ultimately giving us multiple ways to profit from this
investment,” Libassi says.
He says the company felt this was a good time to be moving into the
auto insurance business. After several years of very poor underwriting
results, capacity has exited the sector and rates are starting to harden
as a result.
“This is a true diversifier for our investors that offers very attractive
returns. It is not diversifying just for the sake of diversification,”
ILS Capital has more innovations in the pipeline. For almost
a year, the company has been exploring the possibility of getting
Likening it to the growth of alternative lenders in the bank debt
market in the late 1990s, Libassi and Nealon insist that ILS can coexist
with traditional reinsurance players. From the perspective of investors
and buyers, little would change, but it would afford the company much
more flexibility, mitigate the problem of trapped capital, and reduce
expenses, they say.
To understand how this would work requires some mental gymnastics.
ILS Capital’s investors, much as they do now, would invest in preference
shares linked to reinsurance contracts. Additionally, they would invest
in the equity of the new reinsurance company.
Buyers would have the option of either purchasing contracts backed
by collateral, as they do now, or purchasing a traditional insurance
contract backed by the full faith and credit of the rated reinsurance
company. Where deals are triggered or contracts must pay out, the
structure would allow the company the flexibility to avoid some of the
downsides of collateralised deals.
“For our investors, each contract would be linked to preference
shares, as it is now, but one subtle difference is that investors would
have limited exposure to the equity of the company.
“What we would be doing would be very similar to fronting, and the
economics of that are very attractive,” Libassi explains.
“The elephant in the room for ILS investors is trapped capital. While
investors who committed at the beginning of 2018 were happy with
their investment performance, earlier investors were frustrated with
their inability to fully participate on attractive new investments due to
their trapped capital.
“The team shared in earlier investors’ disappointment with adverse
developments on 2017 contracts and the impact of trapped capital.
“The firm has still not paid claims for 2017 events equal to the initial
reserves established in 2017. We believe that if ILS is truly about
providing investors with attractive non-correlated exposures, in what
way does the nature of the transforming vehicle matter?” he says.
“By converting our class 3a collateralised reinsurer into a class 4,
we can become much more capital-efficient and also write attractive
new business that doesn’t currently meet the firm’s return on capital
criteria. By integrating a rated balance sheet company into the fund,
we give investors the best of both worlds: attractive non-correlated
returns offered by ILS with increased capital efficiency, lower costs and
alignment of interests.”
Nealon argues that this structure has the potential to significantly
grow the entire market.
“I don’t see this as competing with the traditional players. It is just
taking a different approach to matching capital to risk,” he says.
“You are selling cedants traditional contracts backed by a balance
sheet but at the back end, investors are investing in specific contracts
and getting non-correlated returns. If you think about it, it’s the Holy
Grail of this business.”
COVER STORY: ILS CAPITAL