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Opinion: Aeolus and the ILS market’s vicious cycle

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Yesterday sister title Trading Risk broke the news that Aeolus had paused fundraising efforts for the rated vehicle it had hoped to have up and running for the 1 January renewals.

It may well resume work in the New Year, but the flagship initiative will not be live for 1 January as planned, with the focus shifted now to raising funds and navigating the pending renewal season.

The delay is emblematic of challenges facing the ILS market, which has been on the backfoot since the $100bn+ of cat losses the insurance industry absorbed in 2017.

ILS managers face two interconnected challenges that are creating a vicious cycle.

First, the market has persistently failed to generate adequate returns for the pension funds and other capital markets investors that have supported ILS managers.

While some ILS managers will have outperformed the sector, in particular pure cat bond strategies, the overall Eurekahedge ILS Advisers index remains 5% below the levels recorded in January 2017 as the more benign years of 2019 and 2020 were not strong enough to outweigh prior losses.

This index does not include many higher risk-return private funds, but even here investors who missed out on the harder market years and who entered not long before Irma have failed to build up enough cushion for the losses taken. An Arkansas pension fund that this year pulled out of Aeolus and Nephila, posted a small loss on its Aeolus holding since it initially invested in 2016.

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Persistent performance issues in an asset class that is small and non-core where investors can rapidly withdraw their money pose a major challenge for ILS managers looking to maintain assets under management.

This has been exacerbated by the perception that there is a structural ratchet on losses resulting from climate change, and mounting investor scepticism about the grip the sector has on the exposures it is running and the quality of the modelling it is relying on.

All this creates a problem for the sector in convincing investors of its value, which makes fundraising an uphill struggle and also creates downward pressure on fees (also recently seen at Aeolus).

Second, ILS has a structural problem posed by the frequent trapping of capital, which creates an additional drag on returns and can make them unpredictable trading partners.

ILS funds without rated paper or fronting support need to post collateral to write deals, and this can be trapped by counterparties based on buffer loss tables which allow them to initially freeze trust accounts even when their losses are only 50% of the trigger point.

This trapping, which often takes place in Q3 and Q4 given the distribution of cats within a year, then makes the ILS funds writing 1 January deals (including retro) reliant on constantly replenishing their capital with fresh raises. Some higher risk funds have this built into the model through the use of annual closed-end funds, and Aeolus has reported relatively stable AuM at roughly $4bn the past couple of years (down from $4.5bn in 2019, according to Trading Risk figures). But regardless, the essential problem is that the model is reliant on regular successful fundraises.

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And this runs up against the consistent performance issues, which makes ready access to fresh capital a major challenge.

As a result, the ILS managers have become inconsistent in their underwriting in stressed areas like retro, being obliged to drop clients, scale back or damage relationships by leveraging the offer of a renewal to secure capital release.

The perks of a parent

The ILS managers most vulnerable to these twin issues are those which are not tied to broader (re)insurance groups, although of course challenges have not been confined to this group.

As well as leveraging broader distribution relationships, affiliated managers can also potentially call on parental capital to continue to meet client needs, or to use their paper to secure capital release or front deals with leverage.

The second key vulnerability has been ILS managers with a narrower range of high-risk strategies, including areas like aggregate cover, low-attaching Floridian cedants and retro. As in any business, a monoline focus creates a bigger risk if challenges arise in the area where a firm specialises.

Aeolus fits into both groups.

The need to reinvent

Aeolus coming up short in its fundraise for a rated balance sheet dramatises the way in which the interconnected issues of performance and the collateralised structure make it difficult to pivot to address the model weaknesses.

Persistent performance issues make it hard to persuade investors that they should back a vehicle that will address the drawbacks of the collateralised structure, while the same root issue also hampers attempts to diversify into areas like specialty reinsurance as an answer to the over-exposure to cat.

Aeolus has earned a reputation over many years in the broader market that outstrips many of its ILS peers, and it may yet find a way to escape this vicious cycle in the New Year.

But its need to reinvent itself serves as an illustration of the way that the whole ILS market must find ways to evolve if it is to prosper long term.

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