December 9, 2023

According to our sources, insurance-linked securities (ILS) fund managers continue to have success in removing some of the risk from last year’s Hurricane Ian, with some side pockets finalized and trapped funds continuing to be released.

ils fund side pocketsAs we’ve previously reported, ILS fund managers have been able to steadily reduce the size of the investment side pockets they built up for Hurricane Ian.

ILS fund side pockets were established by ILS fund managers as a mechanism to isolate assets that could suffer losses following a major catastrophic event.

They act as a reserve mechanism while capturing the collateral associated with these assets to ensure that they remain available to pay any valid claims or reinsurance recovery.

As industry losses mount, this means that the cedent’s reinsurance clauses remain available and set aside in case specific reinsurance or retrocession contracts are attached.

Last year, in the case of Hurricane Ian and its impact on Florida in September 2022, it turned out that the reserves built by many ILS funds were sufficient to cover the final loss amounts reported by the cedents.

We reported in November 2022 that the ILS Fund’s side pocket for Hurricane Ian, which focuses on private transactions and mortgage reinsurance or retroactive contracts, tends to be 3% to 30% of specific strategies.

Then, in January 2023, we reported that some of the side pockets that insurance-linked securities (ILS) funds had built up after Hurricane Ian were now shrinking as storm estimates continued to fall short of initial expectations.

Most recently, in April, we reported that some ILS fund managers have been able to further reduce the size of their investment funds related to Hurricane Ian.

Now, several months later, we learn that some ILS fund managers were able to completely close small funds related to Hurricane Ian as loss estimates were finalized, all reinsurance claims were paid, and remaining collateral and capital flowed back into their ILS funds.

In some cases, we are told, the funds recovered by the eventual cedent have proven to be significantly smaller than the remaining side pocket capital, even though these side pockets have been shrunk by releasing the capital as losses become more pronounced.

This is another sign of the relatively severe overvaluation of losses in the ILS market after Hurricane Ian, similar to the situation in the cat bond market, where losses ultimately appear to represent a relatively small proportion of the original mark-to-market impact.

As we’ve previously reported, some ILS fund strategies saw between 30% and 80% reductions in remaining Hurricane Ian side pockets, and we now know that some of these strategies ended up with zero losses, while others ended up with relatively small losses and some additional returns on collateral and capital.

Uncertainties regarding the size of Ian’s losses, the size of the cedent’s claims and their reinsurance recoveries have now been clarified, allowing for an accurate valuation of the ILS Fund’s side pockets in some cases, which facilitates the payment of any reinsurance claims and the recovery of any remaining collateral to the ILS Fund and its investors.

We have been told that the ILS Fund has received more finalized loss reports from spinouts over the past few weeks, so some side pockets are being finalized and any funds released should flow back to the ILS Fund and investors in the coming weeks.

These are again very positive signs of how the reserve process in the ILS market is working in the wake of Hurricane Ian, and at the same time the real risk to the market must eventually become clear that some capital will flow back into ILS funds that have had less capital available in recent months.

All of this will help the ILS fund market get ready for the next major trading update at the end of the year, and the experience also serves as a good educational point for existing and new investors.

The final experience of the ILS funds market in Hurricane Ian, which demonstrates a disciplined approach to claims provisioning and management, serves as a case study of how the ILS Market Report can help encourage more capital to flow into the market in a timely manner.

However, we have also been informed that certain instruments and positions remain subject to some uncertainty related to Hurricane Ian, notably certain retrocession coverages as well as the Industry Loss Warranty (ILW).

Given that reported industry loss estimates are now approaching the key trigger point of $50 billion, it may take a while to clear any trapped ILW capital, and in retrocession, it will take longer for reinsurers to understand the final state of their ceded companies before providing a final loss assessment for their own positions.

We hear that there is potential to unlock more private capital related to retroactive contracts in the coming months as ceding reports help reinsurers understand the true state of their exposures.

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