Alternative investments industry body the Standards Board for Alternative Investments (SBAI) sets industry standards and maintains several asset-class specific ‘toolboxes’, designed to provide asset managers and investors active in those markets with guidance documents specific to their needs. Greg Winterton spoke to Thomas Deinet, Executive Director at the SBAI, to learn more about their work in the insurance-linked space, ESG, and alternative credit more broadly.
GW: Thomas, the SBAI’s work in the insurance linked strategy space focuses primarily on the catastrophe risk investing market. What originally drove the decision to create standards specifically for this segment of the alternative credit market?
TD: The SBAI’s Alternative Investment Standards apply to a wide range of alternative investment strategies, including ILS fund managers. But specific practices in areas such as valuations are different in insurance linked strategies compared to other alternative asset classes, such as long short equity, macro strategies, CTAs, credit, etc. With our community of ILS managers and institutional investors, we have identified areas where more clarity and consistency of practices was needed, and then set out to develop industry guidance on these topics which is available in the SBAI Toolbox. Our ILS Working Group brings together institutional investors and asset managers to discuss relevant industry issues and produce practical guidance.
GW: The first resource the SBAI published in this area was focused on valuation. That’s something that is critically important in the life settlement market as well. What are the main points to note in the insurance linked strategy space in this regard?
TD: ILS funds typically invest in a spectrum of assets that may range from catastrophe bonds to private collateralised reinsurance structures. Large catastrophic events are often complex, and the ultimate insurance related losses may not be known for a considerable period after such an event, potentially resulting in material valuation uncertainty over an extended period. The valuation required is a single number, but this number is often the summary of a wide range of potential outcomes.
As there is no secondary market in most types of insurance exposures written by ILS funds, managers are required to derive their own valuations, although third-party valuation firms may be utilised to various degrees in the valuation process. One exception is the catastrophe bond market, for which a secondary market does exist, and third-party pricing indications are available at most times from brokers, although in times of stress the bid/ask spread may be very wide.
While it is clearly desirable to have “accurate” valuations quickly after a loss event, actual loss information will materialise over time as insurance claims are reported, adjusted and settled.
The SBAI ILS Valuation memo addresses this by setting out the key features of a robust valuation framework for ILS managers, including governance and disclosure, valuation policies, and covers ILS specific valuation issues including dispersion of loss estimates, differences in valuation approaches, and side pocket.
GW: The SBAI has done extensive work in the area of responsible investing. How does the SBAI see this in relation to the insurance-linked space?
TD: ILS is an asset class that provides value for society, and therefore can be seen to have inherently positive responsible investment (RI) characteristics. Instruments such as catastrophe, reinsurance or publicly traded bonds provide the means to recover from disasters, helping governments, companies and individuals to rebuild. Dedicated RI approaches within ILS, however, are in their infancy and often do not fit neatly into regulatory or industry-based reporting frameworks. As with many other alternative investment strategies, both the practicality and the effectiveness of RI integration and dedicated RI approaches can vary, and application of these strategies requires careful thought and discussions between asset managers and allocators.
As the focus on RI related risks has increased, these risks have begun to feature more prominently in the investment process. In the SBAI Policy Framework, we highlighted the importance of a flexible and well understood process to ensure that time and resources are spent on the risks that are financially material to the strategy.
Insurance by its nature has long considered environmental risk factors within its investment process, particularly in the case of insurance against natural catastrophes. Social risk factors are also considered by many ILS managers in underwriting decisions looking at items such as claims behaviour and assignment of benefits and others – albeit less explicitly.
Whilst there are issues with transparency of RI data, it is still possible to create internal frameworks to include the assessment of RI related risk factors in the investment process. Asset managers can establish processes to identify and assess RI-related risks and/or opportunities that are inherent in the portfolio. A framework of this sort would integrate RI-related risks and opportunities into the risk management and underwriting process.
GW: Many firms in the longevity and mortality risk space see their industry as being closest to the alternative credit space, and the SBAI has done plenty of work here, too. What are the main similarities or differences in valuation between your ILS and alternative credit toolboxes?
TD: For any type of fund, valuation is the process of determining the fair value of the assets and liabilities that underlie the calculation of the fund’s Net Asset Value at a given time. Valuation can be straight forward for funds that trade in liquid markets, where for example closing prices of securities are readily available, but it gets more difficult when assets or liabilities are less liquid or not traded at all, as it is the case in private credit or private collateralised reinsurance structures.
Robust valuations frameworks for such illiquid assets are important, since they address conflicts of interest between different investors in the same fund where investors can subscribe or redeem from the fund, they address conflicts of interest between the manager and the investors since valuations affect the compensation of the manager, and they facilitate performance assessment and comparison.
The SBAI’s work on Alternative Credit Valuation, available in the SBAI’s Alternative Credit Toolbox, focusses on the fair value process of loans, including Enterprise Value Estimations and Financial Instrument specific valuation approaches. In contrast, for ILS funds, valuation requires the capture of information about material loss events to which the investments may be exposed, to assess the fair value impact of these events.
Irrespective of a fund’s strategy, our Standards and Toolbox materials related to valuations focus on a foundation of strong governance with appropriate oversight, checks and balances. Sourcing and managing accurate data and valuation inputs is also important. We believe strongly in avoiding conflicts of interest and where they do exist in the valuation process, they should be appropriately documented and communicated in a transparent manner to investors.
GW: Lastly, Thomas, the failure of Silicon Valley Bank (SVB) is a stark reminder that banks are vulnerable. What is the key message to institutional investors when assessing counterparty risk?
TD: The failure of Silicon Valley Bank (SVB) is indeed a stark reminder that banks are fragile, and we just published a brief paper on this. For institutional investors, the SVB failure provides food for thought as to how their investment managers and fund vehicles engage with banks and counterparties (such as prime brokers, OTC relationships, etc.) more broadly, as well as the extent to which concentration risk and overreliance can become entrenched.
The fallout of this event continues and there have been a number of subsequent failures. Stress in the US and European banking system is still present. The SVB failure reminds institutional investors that:
i) The financial health and stability of any institution cannot be taken for granted, and
ii) Events in the financial services industry can develop at a rapid pace.
To address some of the concerns raised by the SVB, we have promoted the utilisation of the standardised Administrator Transparency Report (ATR) Template (https://www.sbai.org/toolbox/administrator-transparency-reporting-atr.html), which helps investors identify and track exposure to counterparty risk (including cash deposits) within comingled investment funds through periodic reports. Investors can then aggregate risk exposure across funds to obtain an overall risk perspective. This facilitates ongoing monitoring and informs risk management decisions. It is worthwhile noting that ATRs are common among hedge funds but are not used in venture capital or private equity, where most exposure to SVB resided.
Similarly, Open Protocol standardised risk reporting can be applied to the ILS space and our Toolbox provides guidance on how to do this.
Thomas Deinet is Executive Director at the Standards Board for Alternative Investments