Convergence capital: a life beyond cat?
Cat deals dominate the convergence space, with peak peril risks such as US wind making up a sizable percentage of both the public and private markets. Rising levels of investor capital and an investor set increasingly comfortable with reinsurance risk are helping to drive a bullish convergence market hungry for new and diversifying cat perils, but what about opportunities outside the cat space? Are specialty risks a potential ﬁt for the capital markets and what are the challenges of bringing such deals to market?
Perhaps the ﬁrst major hurdle to diversifying into specialty lines will be securing investor interest. They have grown comfortable with cat risk in recent years, but there are considerable challenges around doing so with specialty. Viewed as a welcome and non-correlating addition to an investment portfolio, cat risk has proved popular— particularly in the current low interest rate environment. Specialtyrisks, however, simply cannot boast the same non-correlated proﬁle, said Bill Dubinsky, head of ILS at Willis Capital Markets & Advisory. The potential for correlation will necessitate considered conversations around such risks, as many might not complement an investor’s existing convergence portfolio or its broader investment allocation, he explained. This will create evident headwinds for any development of specialty convergence products.
Nevertheless, there are areas of specialty risk that could be a good ﬁt for the capital markets. Citing political risk as a case in point, Dubinsky said that many in the capital markets have the skillset necessary to understand and price such exposures. “There are oodles of investors out there who are familiar with political risk—it is part of their day- to-day investments. Sovereign debt has a similar skillset,” he said, so getting comfortable with such deals shouldn’t prove a challenge. The same cannot be said for other specialty areas, many of which will necessarily need to draw on reinsurance expertise.
Specialist investors are likely to be the most active participants in those lines that have traditionally found a home in the reinsurance industry, said Dubinsky, while new and emerging risks may be able to draw on expertise taken from the wider capital markets. What is clear is that investor appetite for specialty deals is likely to be mixed.
Despite these headwinds, “the existing investor set is becoming increasingly broad-minded”, although rather than making sweeping moves into the non-cat space “investors are generally looking to make change incrementally and at the margin”, said Dubinsky. He said that much would depend on the skills of investors, with reinsurance specialists and institutional investors alike looking to leverage existing capabilities to pursue instruments that are well understood, rather than diving in feet ﬁrst.
Pete Cangany, partner at Ernst & Young, spoke in a similar vein, arguing that investor appetite was likely to be “hesitant” as it explored new risks in the convergence space. Cangany said that if such deals were underwritten appropriately, early deals could “prove to the market what can be delivered, and I suspect others will follow”. Specialty risks were likely to be the preserve of those investors that truly understand the market, rather than those hunting for short-term yield, he said, contending that “there will likely be those who will never get comfortable with specialty and non-cat risk”.Development in the space would necessarily need to be led by a well respected company, individual or team of underwriters active in the convergence space, said Cangany. These early players would then open up the market for further entrants. The issue is whether the hurdles around bringing those risks to market are too signiﬁcant to make a serious expansion of the specialty convergence space a reality.
Competing dynamics Perhaps the most signiﬁcant challenge to the growth of specialty convergence products is competition from the traditional reinsurance market. As Martin Bisping, head of non-life risk transformation at Swiss Re explained, convergence capital has been “concentrated around the key cat scenarios and has not branched out to non-peak scenarios or specialty risk. It is quite natural for the peak scenarios to enter the convergence market as from the sponsors’ side there is clearly signiﬁcant need for capacity.”
For companies such as Swiss Re, transferring elements of its peak peril risk—such as US wind—into the capital markets has helped to create additional underwriting capacity and enabled the company to enlarge its global footprint, said Bisping. They are then happy to pass some of that risk on to the capital markets. “When it comes to non- peak perils, however, they nicely diversify our peak scenarios, while there is no obvious need to create additional underwriting capacity. If you get rid of your diversifying risks, your concentration risk becomes more marked.”
Reinsurers will look to retain these risks, said Bisping, rather than see them disappear into the capital markets. As he explained, “There is not a natural ﬁt with a specialty convergence market from a sponsor’s point of view, as they want to retain as much diversifying perils as possible.”
At the same time investor attention was likely to remain on peak peril risks, Bisping argued, where they are able to beneﬁt from the transparency, models and attractive margins that are a feature of cat risk in the convergence space. This is also where demand for capacity would likely remain, said Bisping, markedly reducing opportunities in the specialty space.
Bisping said that while specialty risks could theoretically ﬁnd a home in the convergence market, the complexity of such risks and the cost of funding them through the capital markets would likely make them uncompetitive in comparison with traditional reinsurance. “As a reinsurance company you can write the business without posting collateral, harvesting the full beneﬁts of diversiﬁcation as you expose your capital base to a large variety of risk factors,” Bisping explained. “If you are a collateralised reinsurer, however, you need to post collateral for each and every limit, which makes sense for peak scenarios with relatively high margins. But for diversifying risks, which can be written by reinsurers very efﬁciently, posting collateral just isn’t economical.” Further complicating such deals is their timeline, with investor interest ﬁrmly focused on short tail, cat lines. Longer tail, specialty perils would likely prove a more challenging election for investors, said Bisping. New and emerging convergence perils—should they gain traction—will undoubtedly require close attention. Faced with an unwillingness to cede such business into the capital markets and the cost and complexity of such deals, specialty risks will likely struggle to gain traction.
Model behaviour A further challenge will be around modelling, understanding and building triggers for these specialty risks. As Cangany made clear, the difﬁculties associated with placing risks such as pandemic or terrorism risk in the capital markets are signiﬁcant, with a lack of data presenting a particular impediment to market development. Until the market can accumulate sufﬁcient data on such risks, it will be a challenge to price and structure such exposures, he said. While data for cat risk is considerable, specialty lines simply can’t draw upon the same level of data, he said. Until this changes, the building of triggers, investor conﬁdence and a marketplace will present a considerable challenge.
Bisping similarly argued that the challenges around modelling non-cat risk would likely prove a signiﬁcant impediment to such deals. “Investors simply don’t have the expertise to assess these kinds of specialty risk.” On the cat side there is a high level of transparency delivered by a diverse set of third party providers that can be modelled and quantiﬁed, said Bisping. “But when the deal is complex, unmodelled and opaque it becomes difﬁcult for an investor to absorb that risk.” Complex, specialty risks are likely to be given a wide berth.
Dubinsky agreed that models play an important role in the understanding of risk, but sought to dispel myths around “investors being naive recipients of model information with no real judgement— they simply are not”. He said that models are only part of how they evaluate risk, with tools such as actuarial analyses enabling them to get comfortable with risks that don’t necessarily enjoy the attentions of the main vendor models. Triggers can then be built around this actuarial or modelled data, opening up possibilities to commoditise such risks.
Triggers present a further unique challenge and one that will vary considerably by risk. Industry loss warranty triggers would appear to be a good ﬁt for specialty risks, but Dubinsky argued that while they are helpful in “making risks easier for investors to understand”, they need to be appropriately designed for each individual transaction. He said that an actuarial approach—rather than one based on industry loss—might prove the best ﬁt for some transactions, although such an approach will evidently require existing reinsurance expertise. Such hurdles would tend to favour specialist investors already active in the space.Indices such as Property Claims Services and PERILS in the cat space could also help with the creation of transparent, independent triggers and market data, but as yet the specialty market remains underserved. Until this changes, investors won’t enjoy the same level of access to information enjoyed by the cat space, denting likely appetite in the specialty area.
Limited opportunities Despite marked headwinds, a movement of convergence capital into specialty lines presents an opportunity to broaden the risk-taking appetite of existing reinsurance players. As Dubinsky explained, exposures such as terrorism risk in the US may well be an opportunity for convergence capital to team up with traditional reinsurance capacity to replace the existing government back-stop. He said that this would most likely be through a sidecar or collateralised vehicle, delivering complementary capacity to reinsurance.
Pandemic risk is another potential ﬁt for the capital markets, said Dubinsky, and “one that investors are already comfortable with. It is an area where reinsurers have decidedly limited appetite and I see signiﬁcant risk opportunity there” for reinsurers to increase take-up in concert with the capital markets. Citing the threat posed by pandemic risk to organisations such as international airlines, Dubinsky said that capital market solutions could deliver considerable capacity, with “the best use of that capacity being as a complement to existing re/ insurance—to multiply the risk-taking abilities of existing insurers and reinsurers”.
Working with the capital markets to deploy new capacity to emerging risk will create undoubted headwinds for traditional reinsurers, but investor appetite for new risk remains undiminished. Reinsurers may be forced to accept an accommodation of sorts if investor interest persists, although the strength of reinsurers’ existing value propositions may yet prove sufﬁcient to discourage any major move by convergence capital into the specialty space.
Much will depend on the interest rate environment and the willingness of insurers to explore capital market solutions. For now, however, specialty risks are gaining little traction in the convergence market.