Insurance-linked securities: Embracing catastrophic risks
Insurance-linked securities (ILS) are an asset class based upon insurance events. They provide an element of diversity to portfolios. Put simply, a market collapse is unlikely to be correlated to a natural disaster.
- Insurance-linked securities can be an attractive investment as they are uncorrelated with other assets
- Recent hurricanes in the US have increased the focus on ILS
- In some jurisdictions, insurance-based solutions are dependent on insurance penetration
- There is no reason why ILS cannot protect governments as well as companies and individuals
The core instrument in which ILS funds are invested is the catastrophe bond (CAT). Typically, CAT bonds protect insurers, reinsurers and governments against catastrophic events. Their triggers comprise one or more of the following: a) an indemnity trigger based upon the actual loss or reserves carried by the insurer or reinsurer and relating to a particular natural catastrophe; b) an industry loss based upon an index of industry-wide losses arising from a particular event; or c) a parametric trigger based upon the severity of the event such as a storm measured on the Saffir-Simpson scale or an Richter scale registering earthquake.
With recent hurricanes Harvey and Irma hitting US coastal states after devastating Caribbean islands, there is no doubt that ILS as an alternative asset class have became a focus for various market participants. In particular, it is used by institutional investors including pension and hedge funds as a mean of diversification as an uncorrelated and relatively stable high-yield returns generating instrument.
To date, however, ILS has had a disproportionally large US coastal exposure. The occurrence of two significant and similar catastrophic events following a decade in which few hurricanes have made landfall, has been a real ‘live’ test for alternative capital in the reinsurance industry.
As the ILS market is still young it is hard to overestimate September 2017 as an examination taking the asset class into the new dimension.
Even though early estimates indicate that most ILS investors will avoid direct losses, the framework has been properly stress-tested. This testing has included the overall strategies of dedicated ILS funds, user models, industry loss attachment points and the live cat bonds market. It has also run to broader questions such as proof of the ‘uncorrelation’ argument, attitudes of investors towards trapped collateral, and inflow of further past-event capital. It has even considered the protection gap between insured and overall losses recently reiterated by the World Bank with its Mexican, African, Caribbean and Philippines parametric trigger bonds.
Accordingly, there is no doubt that hurricanes Harvey and Irma will be multi-task learning events as hurricane Sandy was in 2012.
The reaction to such events demonstrate the maturity of the sector. It could be considered one of the key trends for capital and reinsurance markets convergence and a future face of catastrophic risk protection.
ILS came into being after hurricane Andrew in 1992 when capacity in the reinsurance market was squeezed. It has grown significantly since hurricane Katrina in 2005, the financial crisis of 2008 and new risk-based capital regulatory regimes such as Solvency II introduced by the EU in 2016.
The ILS market is flourishing, currently accounting for $90bn (€77bn) of investments. Growth in the market has been strong and the returns good. To an extent, the lack of natural catastrophes in the Gulf of Mexico has assisted returns. That said, the lack of disasters has operated to depress market premiums. Most investors have a sufficient spread of risk to ensure that one loss will leave them with a reasonable return and the prospect of increasing future premiums.
While $90bn is a significant amount and accounts for year-on-year growth over the past decade of up to 10%, it is only a fraction of the investment funds available. The constraint on additional investment is the limit of available investment opportunities rather than the availability of investment funds.
With this in mind, many in the ILS sphere have been exploring ways to increase investment opportunities and present further diverse options. The idea is to allow investors to diversify their portfolio not only into ILS but also within the asset class. Natural disaster and other insurance-related risk do not correlate. For example, Japanese earthquake risk is uncorrelated to North American wind storm risk.
During this search for risk opportunities an urgent need for protection has emerged. Across the world, countries are looking at risks and seeing how these can be protected against and whether the insurance industry alone can bear those risks.
In the UK, this thinking has led to the development of Pool Re and Flood Re. These are reinsurance companies, funded by the insurance industry which have the government as the reinsurer of last resort to provide protection against terrorist risk and flood risk.
In other jurisdictions, governments or quasi-governmental entities have underwritten storm and earthquake risk. The goal is to ensure that the population and commerce is protected in circumstances where the insurance industry is either not sizeable enough to cope or cannot offer terms at affordable rates. Many of these solutions utilise ILS products.
But in some jurisdictions, insurance-based solutions simply will not work because insurance penetration is too low.
In the US, when hurricane Sandy hit in 2012, only half of the economic loss was insured and yet the influx of insurance receipts kick-started the economy of the region which had been dormant since the financial crisis. Shortly afterwards a bigger storm hit the Philippines where less than 1% of the loss was insured. The result was devastation, economic as well as physical.
With economies developing and growing, more parts of the world now have greater economic exposure to natural disaster. Urbanisation adds to this challenge. Insurance penetration, however, historically, lags behind economic growth. The consequence is that many fast-growing economies are woefully exposed to the economic threat of natural disasters. It also means that insurance solutions are not the most practical ones.
Russia is one such country. Insurance penetration in Russia stands at between 1.3-1.4%. It is exposed to several natural perils including wild fires, floods and upon its Pacific seaboard, typhoons. An event could cause significant destruction, human dislocation and economic disruption.
Without insurance, the state finds itself obliged, politically if not legally, to offer relief and reconstruction. It cannot insure against these events without an insurable interest in the underlying risk and without a legal obligation to protect the population, it has no insurable interest. In any event, an insurance solution would require loss adjustment and attendant delay. Money would simply not be available for emergency relief.
Of course, the government could self-insure. This would however, lead to a budgetary crisis should an event occur before the necessary reserve was established.
A better solution exists through ILS. While ILS solutions have, until now, been aimed at insurers and reinsurers, there is no reason why they cannot protect companies, individuals or governments. For Russia, they present the perfect solution to the question of coping with natural disasters in a growing economy.
CAT bonds, based on parametric triggers, provide the Russian government with a means of providing for relief after a disaster and spreading these costs over several budget years. For investors, Russian CAT bonds, provide an uncorrelated asset class in which the intermediaries and frictional cost of insurers and reinsurers have been stripped out.
ILS offers a solution to both investors and governments.
Kirill Savrassov is chief executive of Phoenix CRetro, a niche Bermudian reinsurer and ILS specialist. Clive O’Connell is head of insurance and reinsurance at McCarthy Denning, a London law firm. Rom Aviv is managing partner of IBI ILS Partners, an ILS-focused joint venture with IBI Investment House, an Israeli asset manager