The convergence market is encouraging some creative thinking in the market. Here, we explore some of the key innovations and their implications for the ILS sector.
The convergence market continues to act as a driver of innovation within the wider re/insurance market, with the influx of pension fund capital and a fiercely competitive dynamic helping to encourage creative thinking. A number of developments have been pursued by the market to further enhance its potential, while existing capabilities have been tweaked and refined.
"Other innovations are possible in the field of parametric triggers as the market explores new ways to unlock state-held, underinsured and emerging risk."
Although there has been increased interest in indemnity trigger transactions, which now account for the majority of cat bond deals—spurred on by investors increasingly happy to consider indemnity transactions and by cedants keen to do away with basis risk associated with index and parametric-linked triggers—innovations are nevertheless apparent among trigger types.
Property Claim Services (PCS), a division of Verisk Analytics, for example, has been able to apply its industry loss estimates in the US and Canada “to provide greater flexibility in trigger structure—for both index-triggered and indemnity-triggered transactions”, said Joe Louwagie, assistant vice president at PCS. He explained that some index-triggered transactions had applied PCS estimates to personal and vehicle losses, excluding commercial losses, with PCS helping to transfer more than $1 billion of risk into the capital markets over the past two years.
Louwagie said that developments are delivering greater flexibility in the structuring of transactions, helping the market “refine the evaluation of opportunities, the deployment of capital and its portfolio management”.
"Having the ability to buy in at a low level with a quick time to market will always be appealing to a portion of the investment market."
Innovations have also been made in the area of parametric triggers, with the New York Metropolitan Transport Authority’s MetroCat being a transaction of particular note. Steve Rooney, co-leader of Mayer Brown’s global insurance industry group, who was directly involved in the structuring of the transaction, said the trigger had sought to “as closely as possible replicate MTA’s exposure to storm surge”.
The parametric index uses water level calibrators around New York City to act as a trigger, with the outcome being “a trigger design that makes sense for the MTA”, said Rooney. Other innovations are possible in the field of parametric triggers as the market explores new ways to unlock state-held, underinsured and emerging risk. Risks such as cyber will likely encourage still further creative thinking with regard to trigger type.
Rooney said that there has also been innovation in indemnity deals, with features such as variable resets, which provide a sponsor with “more flexibility in establishing attachment points on a year-to-year basis in order to fit within its broader reinsurance programme”. Such features were not available to the convergence market a few years ago, he explained, but rising investor appetite for reinsurance risk has helped to generate a willingness to consider variable reset transactions, which will likely prove attractive to cedants.
Cat bond lite
Much has been spoken about the potential of cat bond lite transactions, but as Henning Ludolphs, insurance-linked securities (ILS) director at Hannover Re explained, execution has been squeezed by increasing competition in the traditional reinsurance market. “Many of the companies that might have considered cat bond lite transactions as an alternative or addition to their traditional reinsurance programmes are now staying with traditional reinsurance,” he said.
Nevertheless, they remain a “relevant” part of the market and Ludolphs anticipates them becoming increasingly popular should the market harden. “They are a good compromise for medium-sized companies that want to go to the capital markets, but for whom a $100–$200 million transaction is too big. Cat bond lite transactions allow them access to convergence capacity.”
Ludolphs added that while currently such transactions account for less than 5 percent, with some of this business being transacted privately, it is apparent that there is potential for growth. He could see this growing to 10 percent of annual issuance volume.
Louwagie said that if the cat bond lite market continues its “current momentum, gaining a broader base of participants” it could yet “open up a new market alongside the traditional 144A sector”. He said that while it is early days for such transactions, with only seven publicly-traded cat bond lite deals thus far, the market’s interest seems clear.
“If the risk transfer approach achieves critical mass, cedants will have greater opportunity to transfer smaller, targeted risks with lower frictional costs.”
Such transactions are proving appealing to cedants looking to take advantage of current ILS pricing, even in the face of falling rates and improved terms and conditions in the traditional reinsurance space. As David Gibbons, director for assurance at PwC Bermuda explained, “With the abundance of capital in the market and from so many different sources, having the ability to buy in at a low level with a quick time to market will always be appealing to a portion of the investment market.”
Gibbons did however signal a note of caution regarding the durability of the cat bond lite segment of the market. “The question is, will this be the first part of the market to go in the case of a large loss event, or is this an aspect of diversification of capital that will reduce potential exposures and increase the likelihood of the return of capital if an event occurs?”
It depends on the kind of investors who pursue such transactions. For those with little available capital there is likely to be a temptation to withdraw following a loss event, but for large-scale investors greater diversification should help to deliver greater stability for the market, said Gibbons.
There has been a buzz of convergence interest in the casualty and specialty space, but few transactions have yet materialised. As Rooney explained, there is potential to develop longer tail transactions, but there are considerable challenges associated with efficiently transferring that risk.
“Capital market investors tend to like to have a finite end to their reinsurance investments. The challenge is commuting that risk in order to create finality in a longer-tail structure,” he said. Modelling long-term risks is one of the challenges, as is the structuring of such transactions, although he suggested that it was inevitable that the market would explore and create solutions to longer tail risks.
Ludolphs was more bearish about the prospects for casualty risk. “I’m not optimistic,” he said, adding that the timeframes involved would likely make investors wary. “Investors would have to keep a bond until it could be reasonably established whether there is a loss or not, and this wait will serve to dilute the return—you could be earning the same money, for the same risk, but for more years. In such instances there would simply not be enough premium to pay sufficient coupon.”
Ludolphs added that there is potential for other risks to make their way into the convergence market, but that the crucial difference with risks such as terror and cyber is that they are relatively short-tail.
Fronting services have the potential to further simplify the market for investors keen to enter the space. As Gibbons explained, “Fronting services provide the market with an easy way of matching risk to capital.” Capabilities will help to standardise contracts and wording, simplifying entry for an increasingly diverse set of investors, he said. Gibbons added that the volume of transactions and investor interest suggests that there is likely to be still greater appetite for fronting services, but said that investors would have to consider the costs associated with using such services in light of the returns they can expect from convergence investments.
Hannover Re is one market offering fronting services for collateralised reinsurance, with the company “exploring concepts appropriate to meet different investors’ needs”, said Ludolphs. By offering a range of risk transfer opportunities, the company hopes to drive still greater interest among ILS investors keen to take on more reinsurance risk.
Property Claim Services, Mayer Brown, Hannover Re, PwC