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ILS as an investment class could benefit from diversity but this must be done with care. Objective triggers must be created carefully to allow for proper pricing, as Clive O’Connell of McCarthy Denning explains.
In 1992, Hurricane Andrew was the catalyst behind the development of insurance-linked securities (ILS). In 2005, hurricanes Katrina, Rita and Wilma led to the growth and use of ILS solutions. Now, in 2017, hurricanes Harvey and Irma could drive the development of ILS beyond the Gulf of Mexico and US Atlantic coast, and possibly beyond the realm of natural catastrophe.
The recent storms show the use and effectiveness of ILS as a protection product. The insurance and reinsurance industry has been insulated from the significant losses caused by these almost unprecedented storms by alternative capital invested through ILS products. Regulators will look on in the comfortable knowledge that insurers and reinsurers are sufficiently solvent to meet losses at unprecedented levels with little concern about failures. Risk-based capital regimes and the use of ILS within them, have done their jobs.
This proof of the effectiveness of ILS must not go unnoticed by regulators and CFOs. What can assist companies with unexpectedly high losses from natural catastrophes in the Gulf of Mexico, can also help companies facing potential unexpected losses elsewhere in the world and in other risk classes. A truly robust insurance market is one backed by ILS.
Investors should also look at the events of the past few weeks and consider how their ILS strategy needs to develop. While some commentators have suggested that significant cat bond losses might give rise to a retreat from the sector, that view ignores the sophistication of the investors concerned. ILS investors came to the market with their eyes wide open. They knew and understood the risks. They are also aware that the hit that they are now taking will result in better returns in the future.
ILS is a diverse investment opportunity and it remains so. The question that exists for ILS investors is whether the concentration of ILS products in one geographic area and one class of business gives the necessary diversity within that already diverse investment class. The answer is that if other ILS investment opportunities present themselves, greater diversity can be achieved and ILS investors can spread their risk and allow for more sustainable returns.
In other words, the recent devastating storms present a golden opportunity for both insurers and reinsurers and for investors to diversify the range of ILS products available by class and geography.
Indeed, it is not only insurers and reinsurers who can benefit. In areas with low insurance penetration, ILS can present an opportunity to governments and other agencies to plug the protection gap swiftly and allow those entities to spread the cost of a catastrophe or loss over a number of years rather than having to respond to disaster from contingency funds.
One issue that arises in creating ILS products beyond their historic areas is the creation of a trigger mechanism. For Gulf of Mexico windstorm, the question is relatively easy. There are clear parametric triggers available from the objective and scientific National Hurricane Centre. Industry triggers can be structured simply from industry indices operated by established and reputed agencies. Indemnity triggers reflect regulatory filings of companies.
Once one moves out of the established areas, new triggers must be found. Industry indexes do not necessarily exist. Individual companies may not be required to file specific loss figures with regulators. Parametric triggers either may not exist or may be susceptible to influence.
All of these triggers are necessary, not only for establishing what will cause a claim but also for modelling in order to establish a fair and proper price. It is therefore necessary to develop indices or parametric triggers based upon data that has existed for a reasonable period. This can be difficult. The need for products is urgent but data could take years to develop.
The triggers must be objective and safe from influence. For example, an indemnity trigger has to have some external check upon it. While this is possible for natural catastrophe losses where the insurer must report losses from a particular event to a regulator and where the company will have a real interest in not over-reporting, it does not necessarily work so easily for longer tail classes where the subjective element of reserves could give rise to distortion.
With some parametric triggers the issue is complicated. For example, if the agency that controls sluice gates on a river has a direct or indirect interest in recoveries under a parametric trigger, the temptation may exist to flood one area and not another, even though proper flood management might point the other way. If a large local insurer stood to gain from a particular acreage of flooding, a governmental anti-flood agency might be pressured to maximise recovery to benefit the national economy. This action would invalidate pricing models.
The recent storms have shown that ILS works and that ILS needs to be used across the world in many classes of risk. It has demonstrated that ILS as an investment class will continue but could benefit from diversity. Any development of ILS, however, must be done with care. Objective triggers must be created carefully in order to allow for proper pricing.
ILS, born from Andrew and developed by Katrina, Rita and Wilma, has now come of age with Harvey and Irma.
Clive O’Connell is partner, head of insurance and reinsurance at McCarthy Denning.
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