Much is spoken about the need to encourage greater innovation in the sector. Convergence capital may just deliver some much-needed impetus.
Few areas of the market have been more in tune with innovation than the convergence space, with the influx of new capital helping to reinvigorate thinking in the market. As Kent David, vice president of consulting services at EQECAT outlined: “Innovation has been the life blood of ILS, with convergence capital exploring new instruments and ways of ceding risks into existing structures.”
It is unlikely that the industry has seen the end of this new drive for innovation. As Spencer Conway, CEO of Kalista Global indicated, “This is just the start. People are only just beginning to realise what’s possible in the convergence space.”
One of the possibilities highlighted by Conway is the potential to bring new risks to market with the help of capital markets capacity and re/insurance expertise. Highlighting the new MetroCat transaction, which meets the risk transfer needs of the New York Metropolitan Transportation Authority and will protect the authority against storm surge for the coming three years, Conway said that such deals reveal the resourcefulness and initiative of the people structuring and bringing to fruition such capital market deals. Transactions like MetroCat require “a very specialist, bespoke and connected team to pull those transactions off”, said Conway. A drive for innovation will be in their DNA.
Paul Schultz, CEO of Aon Benfield Securities, agreed that the market has grown increasingly innovative, “moving away from its early roots to develop alternative triggers and coverage for more diverse and less well-understood perils”. He said deals such as Tradewynd Re, which provides wind and earthquake coverage to AIG, are evidence of a market “growing in maturity and sophistication, able to understand and write increasingly complex transactions”. As Schultz explained, “We’re now getting into a broader definition of risk.”
Innovation by degrees
One of the key ambitions of the convergence market is to increase liquidity and transparency, and the creation of a true trading environment. In this sense the market has come some way since its early days, said Schultz, with disclosure now being carried out in an increasingly meaningful way, making coverage and risk as transparent as possible. Addressing the secondary market, Schultz said that it “provides mark to market on a weekly basis, which is helpful in providing investors with a current view of the risk on their portfolios and gives potential investors an opportunity to look at pricing and discover trading patterns—how the market reacts to different events, whether they are events that can cause potential loss to the market, or other financial snares”. This level of price discovery helps to instil confidence in the market, drawing still further investors into the space.
David concurred that there has been innovation around better transparency in order to satisfy investors, but also to make triggers more easily understood, and in order to meet the requirements of the rating agencies. Nevertheless, he said, there was room for improvement, particularly when it comes to simplifying transactions.
Innovations have also been seen in the types of trigger used for cat bond transactions. As David explained, “In the early days pure parametric transactions predominated, being easy to quantify, the data readily available and the deals transparent. The second generation were parametric indices, which required a considerable amount of innovation, but could deliver improved accuracy to trigger parameters.”
These initial developments have since been followed by industry loss transactions that have benefited from the work of Property Claim Services in the US and PERILS in Europe. “Organisations such as PERILS have given the market the opportunity to access independent, wellrefined reporting mechanisms that have greatly improved the ability to trade European windstorm,” said David. Still other deals are based on indemnity triggers, with such triggers proving increasingly popular— particularly among cedants. David said that the increasing employment of such triggers is indicative of “a growing sense of trust and acceptance of the mechanism within the industry and among investors”.
Not that there isn’t any room for innovation in ILS triggers. David said that there is talk of using triggers that use satellite photos for flood risk and remote sensing—“anything that can be transparent and rapid can be a potential trigger mechanism”. Conway agreed, adding that the industry would likely see “more bespoke triggers wrapped around innovative structures”. It may take some time for the industry to fully understand and trust such innovations, but there will undoubtedly be interest in its heading.
The modelling of risk has also come on considerably from its early days, with the market able to draw upon an increasingly diverse set of models. As Schultz explained, “The market is moving towards a multimodel perspective of risk and is looking to establish a more collective view of risk.” Looking ahead, he said that underwriting insights will form an increasingly important part of the modelling process, with vendors delivering customisable solutions that enable cedants to input their own loss data as opposed to delivering an industry-based solution.
Developments in the space also raise the prospect of off-the-shelf solutions that could attract still further cedants and investors. Schultz said that Aon Benfield Securities had made some ground in making structures and documentation more replicable. While he agreed that the unique nature of risks often leads to customisation and bespoke features, “the market is generally moving towards more rapid trading”. This will necessarily require simpler solutions and in order to issue faster players will draw upon existing documentation where possible, he said.
"Organisations such as PERILS have given the market the opportunity to access independent, well-refined reporting mechanisms that have greatly improved the ability to trade European windstorm."
“Not needing to re-draft documents or re-create analyses can create pricing efficiencies, making the product more efficient in the marketplace. All of us are cognisant of that and trying to move the market in that way,” said Schultz.
David said that Swiss Re has done exactly this with shelf programmes, where they include a large library of tranches of risk in their circular to market, but in the end market only select tranches. He said that issuing other tranches can be done with ease and minimal cost, although “there are nevertheless some frictional costs in any offering”. For some cedants an off-the-shelf approach might suit them best. “Sponsors may well have a very clear idea of the risk that they want to cede, so sponsors with a global book of risk can approach the market with a library of potential tranches included in a shelf programme.”
A new heading
Traditionally the focus of convergence capital has been very much upon reinsurance and catastrophe risk, but as the space develops—and innovates—there are opportunities for new risks to enter the market. Conway predicts that a broad array of non-cat risks will make their way into the convergence space. “People are wising up as to what their options are and you’ll see a broad range of speciality risk enter the market—everything from contingent business interruption to marine and aviation. And there will be broad innovation in the way that these deals are structured.”
Schultz said that the current focus of alternative capital is very much on cat risk, but “as the market becomes more mature and sophisticated in terms of underwriting and understanding risk, it’s logical that this market will evolve into liability or casualty-types of products”. He said that there is already work being done in the life and mortality markets, with specialty and casualty classes being the “natural progression down that path”. Schultz said that this would not all come in the form of cat bonds, but a range of collateralised products that the capital markets can participate in. He said that this would likely result in new structures, with rather different asset profiles, capable of grappling with these more long tail lines.
Taking on non-cat lines will require further model innovation, said Schultz, with some serious thinking needed around “how such exposures are modelled and how they can be put into a finite term structure like a bond or collateralised reinsurance contract. That clearly is something that will be worked on by many parties”, he said. Schultz said that it was up to the market to provide cedants and investors with the most effective structures for such risks.
What is apparent is that new capital will force a rethink in reinsurance circles and drive much of this innovation. “For a long time the industry didn’t really buckle up, look over its shoulder or worry about competition,” said Conway. “Rising levels of alternative capital will mean that the market is going to get a lot more aggressive.”
The current spike in alternative capital is a “combination of risk buyers feeling a need for a more bespoke solution and the fact that there’s capital out there willing to listen for the right solution”.
“What we all want to do is bring more capital to the market and have it grow—and it’s not just in ILS,” said Schultz. “We want the insurance product that’s sold at the street level to be much more interesting and attractive to the ultimate client. We want the reinsurance product to bring more capacity to the primary level and let primary insurance companies write more business and we want to continue to deliver products that are relevant.” That is going to require innovation.
“The challenge will be how to keep embracing this new world, and figuring out how to utilise that capital for your franchise to make your products and value proposition stronger,” concluded Schultz.
Innovation in triggers?
Innovation in trigger type isn’t clear cut, as David made clear. “In some sense, the graphs on page 46 and below make the argument that the market is becoming less innovative as one could argue that indemnity deals are the least innovative trigger type—they are simply the losses realised by the sponsor. This argues that innovation in and for itself isn’t of great interest— basis risk reduction is a large driving force for sponsors interested in an indemnity deal,” said David.
“There is also more of a historical story to be made here—the parametric index deals started a steep decline in 2010 which is at least partially due to the emergence of PERILS as an industry loss basis for risk cessions for European windstorm.”