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With the key January renewals approaching, two notable provisions have seen a re-emergence within the insurance-linked securities (ILS) market: Claw-Back and Top-Up, both of which may seem straightforward but require careful structuring and clear language, according to Andre Perez, CEO of Nascent Group, the technology-driven financial service provider.
In a recent whitepaper, Perez explains that while both provisions may require investors to add funds to the collateral account, they serve very different purposes.
Perez describes Claw-Back as a mechanism requiring previously released collateral to be returned to the collateral account due to deteriorating incurred losses.
In contrast, Top-Up requires additional collateral to offset shortfalls caused by investment underperformance, which is more typically seen when funds are invested in instruments riskier than cash or T-bills.
“The goal is to avoid surprises – neither side wants confusion about their obligations if either clause is triggered. At Nascent we go through a diligent review of each contract’s wording and advise all parties on how to best handle these clauses in order to safeguard their interests,” Perez explained.
Outlining the key considerations that investors should be aware of when it comes to claw-back provisions, Perez said: “Collateral release provisions are typically well-defined and negotiated. These are negotiated by both parties, and it is incumbent upon the cedant to ensure that the collateral is not released prematurely. Obviously as part of the negotiations of collateral release provisions, investors will push as well for collateral to not be unreasonably withheld by the cedant. Claw-back clauses introduce post-release uncertainty, which can undermine investor confidence and valuation certainty.”
Without disciplined release terms, investors risk losing valuation certainty, which remains a growing concern amid tighter ILS capital flows.
The whitepaper also notes that transformers which are independent from Investment Managers may face challenges retrieving previously distributed collateral if a claw-back is triggered. Perez warns that without protective language, such events could lead to cell default and jeopardize the transformer’s regulatory standing.
In addition, Perez also referenced the Bermuda Monetary Authority’s (BMA) updated draft guidance note, which emphasizes the requirement for explicit contract language: if collateral is released while a policy remains in force, the BMA’s current expectations is that there is reinsurance contract language whereby the policy limit must reduce by the same amount, which the CEO states is an important requirement that needs to be emphasized to the ILS market.
“Essentially the BMA is no longer accepting sole reliance on Limited Recourse Clause as evidence of full funding. As an insurance manager and transformer operating under BMA regulations, we help clients review contracts, monitor collateral, and track obligations in order to ensure compliance with BMA requirements.”
Moreover, the whitepaper further highlights that the Limited Recourse Clause (LRC) is now a standard feature in collateralized reinsurance contracts. Correctly worded, it limits the cedant’s recourse to the reinsurer strictly to the assets within the collateral account. Perez advises this restriction for two main reasons
Firstly, the CEO explains that released collateral remains part of the cell’s assets even if it is no longer part of the collateral account, which could restrict investor distributions if the released collateral of the contract is not commuted or if the limitation is to the assets of the cell rather than the assets of the collateral account.
Secondly, Perez outlines that investment instruments (whether it be subscription shares or notes) are considered assets of the cell.
“Should there be provisions in the instrument allowing the cell to demand additional funds from investors, the cedant may argue that it has access to additional funds from investors by claiming ownership of the instrument. To avoid ambiguity, we recommend the LRC to be limited to the assets of the collateral account and furthermore explicitly state in the reinsurance agreement that any claw-back provision is subject to the LRC,” the whitepaper reads.
“From the cedant’s perspective, having the ability to claw back collateral offers a safety net in case losses deteriorate after funds are released. But from the investor’s side, that introduces a valuation post-release uncertainty. As an independent transformer, Nascent Re does not control investors’ funds therefore we need to protect ourselves should we encounter difficulties in obtaining additional investors’ funds – which is why proper contract language is crucial,” Perez added.
Turning to top-up provisions, Perez described them as “a double-edged sword” for ILS fund managers.
“On one hand, they provide some investment flexibility. On the other hand, if the assets backing the collateral drop in value at the wrong time, a top-up trigger can suddenly call for fresh capital. If markets are in turmoil, that’s the last moment you want a margin call.
“We advise funds to honestly evaluate their ability to meet such capital calls under stress. Often, it may be better for a cedant to either accept the risk of investment underperformance or require extra collateral at inception, rather than relying solely on a top-up clause to patch a shortfall,” the CEO explained.
To conclude, the whitepaper states: “Claw-back and top-up provisions require careful structuring and clear language. While contract terms may protect investors from additional obligations, voluntary additional collateral contributions remain a commercial decision.”
Claw-Back and Top-Up clauses return to ILS; Nascent’s Perez urges caution and clear structuring was published by: www.Artemis.bm
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