Tuesday, May 19, 2015
Dr John Seo, Co-Founder and Managing Principal at Fermat Capital Management, LLC discusses the rise of complex, non-transparent risk bundling within the reinsurance industry and how the cat bond asset class is unaffected by this.
- The creation of complex, non-transparent bundles of reinsurance risk has been highlighted in the media recently, with parallels being drawn to the subprime crisis.
The reinsurance market features opaque instruments and it is easy to see how market commentators are piecing together snippets of information to draw hard conclusions on industry developments. Such conclusions have subsequently misleadingly been linked to cat bonds.
The fact is that the bundling of non-transparent risk is not currently impacting the cat bond market. Where it is occurring elsewhere in the reinsurance universe, the risks are being passed on to professional parties which are capable of assessing and setting upper bounds on the levels of exposure they are taking on – so are making informed purchase decisions. We are not seeing any trend towards disguising toxic risk assets and passing them off to unsuspecting parties. Indeed, these complex bundles are only accessible by professional industry parties; they are not being sold in the securities market to unsuspecting investors. To link reinsurance risk bundling to subprime debt is a misinformed comparison.
Bundling for good
Risk bundling is actually reflective of a larger, positive industry trend. The bundling of complex risk goes hand in hand with the greater retention of risk by global insurers. If global insurers were not retaining more risk, but merely re-packaging it into more complex packages, then we could see a potential, systemic issue on the cards. However, global insurers are not just re-packaging their risks; they are radically restructuring how they self-manage their risks.
Global insurance companies are shifting their reinsurance buying from income protection to capital protection. This results in two things:
- Global insurers are retaining more risk to minor catastrophe losses, which means that they are increasing, not decreasing, their responsibility for their underwriting choices. They are particularly focussing on minor catastrophe zones, which have previously been the traditional domain of specialty reinsurers.
For example, prior to 2010, the well-known global insurance company AIG had no significant in-house catastrophe modelling group. Because in recent years AIG made the choice to retain more of its own risk, it has subsequently developed a global modelling group centre (established in October 2013), staffed with 300 engineers and catastrophe modellers in addition to smaller, regional catastrophe modelling groups.
- Global insurers are increasing their solvency protection – which they must eventually do under impending Solvency II regulations – by buying more reinsurance for truly super-catastrophic events that threaten their core capital base, particularly in major catastrophe zones. These are the classic domain of cat bond markets. In a sense, large insurance companies are literally outgrowing all but the largest reinsurance companies.
For example, QBE Insurance, through the steady acquisition of smaller, local insurance companies worldwide, has grown its premium volume from USD 1 billion in 1994 to more than USD 17 billion in 2013. Only Munich Re (USD 23 billion) and Swiss Re (USD 21 billion) have a higher premium volume.
Shifting for self-reliance
The bundling trend is therefore part of a larger industry shift toward more self-reliance on the part of global insurance companies, which we view as a responsible, positive development. Global insurers are now able to internally consolidate more of their risks thanks to their vast size and greater business diversity, retaining more risk, then reinsuring for losses at the global company level in both the reinsurance market and the cat bond market. Reinsurers may at times be faced with difficult-to-evaluate, complex bundles of reinsurance risk, but because truly catastrophic global insurance company losses involve only a small handful of geographic zones, typically in developed markets and the US in particular, catastrophe bonds are not called on to cover obscure areas of the globe. A typical cat bond might cover a hurricane in Florida or an earthquake in California, for example.
The complaint of specialty reinsurers is that this trend toward greater self-reliance decreases the importance of their role in the changing reinsurance landscape. At the same time, cat bonds are gaining prominence as solvency protection increases in importance among all insurance companies.
Some specialty reinsurers are mistakenly seeing cat bonds as the root cause of the pains they are experiencing. Cat bonds are certainly not helping specialty reinsurers, but the real problem is the secular shift in the reinsurance buying habits of large insurance companies, which historically have been the best customers for specialty reinsurers. This secular shift is driven by the cumulative effects of growth by merger and acquisition, which has been a prominent feature of the global insurer space for several decades now. Cat bonds, with their exotic and esoteric reputation, seem to have become the unfortunate scapegoat for the misinformed.
Nowhere to hide
Reflecting on the cat bond market, one notable point is its size. There are currently 135 outstanding bonds1, making it a manageably sized investment universe to monitor and research – it would be hard to conceal these alleged bundles of rogue investments within such a modest pool of assets. Of these 135 bonds, only a dozen are issued by global reinsurers and the risks are highly focussed, clearly specified and model-able. In terms of liabilities, these always stop with the insurer – there is no risk of liability gaps being passed on to the investment community. The maximum loss an investor is exposed to is the value of the bonds they hold.
While not comparable to pre-crisis subprime MBS, cat bonds are a sophisticated and complex asset class not suitable for all investors and portfolios. Given their low correlation to mainstream assets and potential for attractive returns, an allocation to cat bonds has the potential to provide a tangible improvement to the risk / return profile of a typical investment portfolio. The likelihood of a bond triggering is low, but when it does occur losses can be significant.
Yet, the proportional benefits of choosing an active strategy are hard to overstate. The experienced and dedicated active cat bond managers have established a strong position over their peers in terms of analytical and portfolio modelling technology, market access and size. As a result, their strategies may be able to minimise the risk element of cat bonds and focus on harnessing the systemic returns that make the asset class such an attractive proposition for the long-term investor.