As the hurricane season hits full swing, the ILS market needs to be prepared for the consequences, says Bill Dubinsky, managing director, head of insurance-linked securities at Willis Capital Markets & Advisory.
The official start of the hurricane season is an unofficial warning to those in North America and the Caribbean to make sure they are prepared.
For insurers in the Florida market, the start of hurricane season is the time to have all risk transfer (whether backed by the Florida Hurricane Catastrophe Fund, traditional reinsurers or capital markets capacity) in place. Insurers also rededicate their claims handling teams to provide responsive service under high volume conditions.
For reinsurers and investors, it is time to finalise portfolios. Traders and intermediaries prepare for live and dead cat trading and review their post-storm strategies.
June 1 officially marked the beginning of hurricane season in the Atlantic, which cumulatively increases throughout the summer, peaking from August to mid-October (Figure 1). Approximately 62 percent of storms make landfall during this period.
Tropical cyclones worldwide exhibit a strong seasonality. Each hemisphere has a different season and within each hemisphere seasonality varies by tropical basin. Even within each basin, landfall patterns vary considerably during the year. In the Atlantic basin, dangerous Cape Verde hurricanes rarely make landfall in southeast Florida early in the season.
Other natural catastrophe perils exhibit strong seasonality, such as European windstorms and North American winter storms. Flooding danger can also vary tremendously, at times dependent on other natural catastrophes such as hurricanes. Wildfires occur during times of drought, high temperatures and high winds, although there are always anomalies such as the recent Alberta fires.
Some financial and liability lines can have seasonal loss and reserving patterns (sometimes with a lag) driven by seasonal economic activity. For example, retailers may have more employment-related disputes and associated claims arising in the holiday season. This is similar to other financial metrics such as receivables and inventory for seasonally impacted businesses such as airlines, amusement parks, and Broadway shows.
Financial impacts of seasonality on ILS and otherwise
If we map from events to losses, we can also examine the financial impacts on portfolios of insurance-linked securities (ILS) investors. Unfortunately, it isn’t as simple as matching valuations to underlying loss activity.
As a preliminary issue, re/insurance seasonality is complicated by the reserving and payout process. Neither cash flows nor accounting numbers move in lockstep with underlying events. Reserves can strengthen or prove redundant and even for a fixed ultimate loss; payouts can speed up or slow down. Companies do not have perfect information and early estimates can prove quite wrong.
Even assuming information was perfect, the reality is that a number of other factors come into play with ILS because the ILS market has some non-insurance influences on valuation. After all, it is a convergence market heavily influenced by financial market norms. Some but not all of these factors add to transparency in valuation.
First, ILS fund inflows and outflows themselves have seasonality. Investors tend not to commit new funds (or withdraw them) evenly throughout the year nor do the commitments and withdrawals perfectly line up with the underlying investment opportunities. Many investment opportunities line up with key reinsurance renewal dates such as January 1, April 1, June 1, and July 1 but inflows occur at different times, such as mid-January.
These cash flow mismatches may have a knock-on impact on valuations in the absence of external players smoothing liquidity shortfalls and excesses. Loss activity can exacerbate these intra-year cycles as capital gets locked up and unavailable for new investments.
As we addressed more completely in our most recent ILS quarterly, such valuation changes from these and other causes are readily observed with respect to liquid ILS with regular secondary market activity. Net asset value (NAV) calculations based on a mark-to-model approach will solely reflect an often imperfect view of seasonal loss patterns (and will ignore seasonal volatility altogether as a separate influence on valuation). Depending on the portfolio, “imperfect” can shift to “flawed”. A “flawed” NAV can in turn make fund entry/exit unfair for fund participants.
We do see a handful of ILS investors who really try to understand these various forces and use them to their advantage. They may develop a slightly contrarian trading approach as they try to take advantage of some of these seasonal idiosyncrasies of which they believe their peers are blissfully unaware.
Some investors go further by modifying their allocations between various products (industry loss warranties, cat bonds, collateralised re, etc) throughout the year based on the seasonality and varying risk return patterns. We also see brokers and protection buyers who can take advantage of cheaper and more predictable execution by changing the timing of their re/insurance purchases.
Indeed, more understanding of and attention to seasonality in all of its various forms can not only help grow and improve the ILS market but also make the broader re/insurance markets more effective and efficient.
Bill Dubinsky is managing director, head of insurance-linked securities at Willis Capital Markets & Advisory. He can be contacted at: firstname.lastname@example.org
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