Trapped Collateral Explained
In the ILS and reinsurance industry, trapped collateral refers to capital provided by investors that is held, or ‘trapped’, by the reinsurer or special purpose vehicle (“SPV”) after a catastrophic event. This occurs due to uncertainty surrounding potential loss payments, as the total amount of claims arising from an event, like a hurricane or earthquake, is not immediately clear. Insurers must hold the collateral to ensure sufficient funds are available to cover future claims. This can tie up capital that could be used for new investments or writing new policies.
Managing Trapped Collateral
There are several strategies insurance companies can use to manage trapped collateral. For example, sophisticated Risk Modelling allows insurers to estimate potential losses from catastrophic events. This helps determine the amount of collateral to trap and enables the release of excess collateral when the risk is deemed lower.
Additionally, insurers monitor Loss Development over time to assess whether trapped collateral remains necessary. As claims are settled and the total loss becomes more certain, insurers can release excess collateral back to investors.
Insurance contracts may also feature Collateral Release Provisions. These define specific conditions under which collateral can be released. Provisions can be based on factors such as time, loss development, or other criteria. In some instances, insurers can Purchase Additional Reinsurance or Retrocession Coverage to protect against the risk of trapped collateral, transferring some or all of the risk to another reinsurer or an ILS fund.
Solutions to Recover Capital
Investors have several options to recover their investment capital.
One route is to sell their ILS and reinsurance contract positions on secondary markets, potentially recovering some or all of their investment capital, even if the underlying collateral remains trapped.
Alternatively, investors may negotiate commutation agreements with reinsurers, which permit the early release of trapped collateral in exchange for a negotiated settlement amount. This approach can rapidly expedite capital recovery for investors.
Investors may also consider a loss portfolio transfer (“LPT”). This involves an insurer transferring a portfolio of loss reserves to another party, typically a reinsurer, in exchange for a premium.
Other options are available for investors to explore, such as structured solutions that offer greater flexibility in releasing trapped collateral by, for example, investing in multi-year, multi-event ILS structures, which allows for more efficient collateral use across multiple events and years.
Investor strategies for recovering trapped collateral
