Models: what really matters


Models: what really matters

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William Dubinsky, managing director & head of ILS at Willis Towers Watson Securities, takes a look at model clarity and other issues facing the ILS market.

Against a backdrop of a contentious Florida reinsurance renewal and with losses from California wildfires still stinging, the importance of models to investors in insurance-linked securities (ILS) has never been greater.

Traditional catastrophe models remain at the centre of pricing, and are undergoing updates with new data from 2017/18 events. Meanwhile, as losses creep relentlessly higher, actuarial models for post-loss analysis are in the spotlight, given their role in collateral management and industry loss warranty triggers. Finally, the importance of valuation models is coming to the fore.

The growth of the ILS market continued to slow in the first quarter of 2019, following a reduction in Q4 2018. Slightly more than $1.1 billion was raised through non-life catastrophe bond issues, compared with an average of $1.8 million over the most recent six first quarters. It is the lowest total achieved for a Q1 period, highlighting pull-back by some investors, and around one-third of the record-breaking activity observed in Q1 2018.

The slowdown seems to be on the supply side. Weighted average last-12-month risk premium for non-US wind-exposed bonds jumped 2.2 points to 6.50 percent during the quarter, while premium for US wind-exposed instruments rose 0.3 points to 6.10 percent. Seasonality has contributed to market heaviness, while loss-affected bonds continued to be marked lower.

Decreased investment does not reflect a long-term change in capital markets’ appetite for ILS risk. Instead, some investors are understandably looking harder at the mechanics. They see data quality and accurate modelling as essential, and have put them under scrutiny from the initial pricing throughout the life of a transaction.

Model clarity is key to rebuilding the confidence of alternative investors, since it builds understanding of the nature of the investment opportunities floated by cedants. Recent cases of loss creep have put actuarial models to the test, and given investors a much greater understanding of the phenomenon.

In future they are likely to look closely at issuers’ records of timely and transparent loss reporting when making allocations. Of course, transparency alone will not eliminate reserve volatility, which is inherent to a business where every event differs from its predecessors.

Few non-life reinsurers regularly mark their reinsurance contracts to market. In contrast, current valuation is a big issue for ILS funds and end investors, since current values have a significant impact on fund entry and exit, as well as management fees and access to leverage. Given this investor need, current modelling methods are being critically assessed.

Valuation methods

Valuation methodologies differ dramatically between funds. This is due not only to differential treatment of reserves and payout patterns, but also because of the extent to which illiquid and partially liquid positons are marked to model rather than marked to market. If cat bond prices change 20 percent, do related private investment prices change 20 percent?

If dead cat spreads increase, this strongly implies lower valuations on illiquid positions. Is this taken into account? When changes in the liquid market are ignored for the wrong reasons in valuing illiquid instruments, it can lead to potentially misleading valuations, understatement of volatility, and a portfolio mix skewed to illiquidity out of a false sense of stability.

Harmonisation of valuation practices for ILS has been slow. Speeding it up to bring more consistent valuation approaches may spur substantial growth i n ILS capacity. End investors would likely gain further confidence in evaluating potential managers and making new allocations to the asset class, kick-starting sluggish investor appetite.

Transparency is crucial, especially in post-loss reporting, which is becoming an important differentiator for cedants. Enhanced understanding on all sides, including with cedants, has had a flow-through impact on collateral release arrangements, which are negotiated with a better awareness of the economically realistic potential outcomes.

The industry has realised it needs to raise its game, and that effort is under way. Its success will be vital to maintain and restore long-term trust relationships between investors and cedants, and to restore the healthy flow of capital into ILS markets.

Willis Towers Watson, models, risk modelling, analysis

Bermuda Re