The conclusion of another year marked by natural disaster has once again served as a timely reminder of the increasing value of insurance-linked securities (ILS) to the global (re)insurance market1.From inception in the late 1990s, the ILS market has expanded rapidly since 2012 and now contributes approximately USD 80-100 billion, around 20%, of additional capacity to the global reinsurance marketplace2.
The ILS asset class offers capital market investors a mechanism to provide new capital to the (re)insurance sector and an effective means to satisfy the increasing requirement of insurers and reinsurers to reduce risk on their balance sheets while continuing to provide protection to the areas of the world – known as the ‘peak peril’ zones – with the greatest but also rapidly escalating demand for insurance.
ILS returns are driven by a fundamental mismatch between reinsurance regulation and the demand for insurance created by an intense and growing concentration of the world’s population, wealth and property in urban and coastal areas that is accelerating exposure to disasters, both natural and man-made. In some of the largest peak peril zones – states on the US coastline at risk to hurricanes – the insured value of properties, and therefore potential insured losses, have historically doubled every 10 years3. However, in the decade from 2007 the total traditional global reinsurance dedicated capital base – the pool of capital available to backstop insurance companies – only increased by an estimated 33% to reach USD 350 billion in 20174,5. Due to regulatory pressures this total global reinsurance capacity is spread roughly equally across insured risk exposures, with only approximately USD 40 billion of reinsurance capital available for any given peril (for instance hurricane risk in Florida6) . Given one large catastrophe – such as a Category 5 storm hitting the most concentrated property exposures of Miami directly – could cause insured losses to exceeded USD 250 billion in just one event7, it is clear the (re)insurance industry – while adequately capitalised for normal disasters – is grossly under-prepared to meet the cost of remote but potentially devastating catastrophic disasters that are now possible today, let alone meeting the increasing demand for insurance to cover risks that are currently under- or uninsured.
ILS filling the large gap left by the reinsurance industry
The horizonal profile of the reinsurance market is fundamentally at odds with the vertical extent of the world’s underlying insurance exposures, creating a structural and growing ‘disaster gap’ composed of insured and under-insured risks – estimated at over USD 500 billion8 – that are unserviceable by traditional insurance and reinsurance mechanisms. Whereas in the past increased demand for reinsurance capital would have been met with new reinsurance company formation, this response is no longer competitive in today’s regulatory, rating and market environment. With demand for risk capital outstripping supply, this large gap left by the (re)insurance industry may create a compelling opportunity for a capital markets solution.
While different in form, ILS instruments – catastrophe (cat) bonds, collateralised reinsurance, industry loss warranties and sidecars – function similarly to traditional reinsurance and offer investors a return in exchange for accepting a share of risk exposures from insured events that cause the most stress to (re)insurer balance sheets. This means bearing the risk of losses should defined insured events – such as hurricanes, earthquakes or, more recently, wildfires – occur but, in the absence of major catastrophes, receiving an inherently stable yield with a low correlation to traditional financial market sources. In addition to (re)insurers, ILS are also increasingly being used by companies and governments to manage the cost of extreme risk events, including the US Federal government through the National Flood Insurance. Program’s first catastrophe bond issuance in mid-20189 and the World Bank, which now directly issues cat bonds on behalf of countries seeking to manage their disaster risk pro-actively10 . While these instruments currently only penetrate a small fraction of the risks in the present-day disaster gap, with limited opportunities for new capital formation within the traditional reinsurance sector in contrast to accelerating capital need, the dynamics are set for substantial ILS market growth ahead.
In order to acheive long-term positive ILS returns, we believe it requires experience and active management at every stage of the investment process. It is essential to scrutinise the structure and legal aspects of each security, as well as the modelling of each risk. If a security does not pass these quality tests, any numbers generated from the risk models for it can be meaningless. If it does pass this due diligence test, the next step is pricing and selecting the security for investment.
ILS are part of the vast global (re)insurance market, which covers a tremendous variety of risks. The central challenge for investors in this asset class is not to indiscriminately expose themselves to all of these risks just because they exist in the insurance market. Once taken out of the traditional (re)insurance market context many of these risks are not suitable as investments. The key is to find those parts of the market which pay a systemic, excess return that is well above the modelled uncertainty of these risks.
Our approach is to construct portfolios with what we call ‘good bones’: a risk/return structure which aligns with the finest paying reinsurance risks. We focus on ‘peak perils’ – the most modelled and well-understood risks that dominate the global insurance market – while maintaining a rational level of diversification.
As part of our management of ILS strategies we use outputs from catastrophe risk simulation models developed by leading modelling firms such as AIR, CoreLogic and RMS, as well as our in-house analysis. For US hurricanes, for example, these models have been calibrated with over a century of hurricane data – covering periods of both high and low hurricane activity – to provide a range of specific events and a long-term profile for hurricane risk against which transactions can be evaluated and portfolio risk can be analyzed. Using ‘climate conditioning’ – that is only using historical years when the Atlantic Ocean has been warmer than average (and therefore closer to current sea surface temperature conditions) to calibrate the models – their output also allows us to assess the sensitivity of specific transactions and our portfolios to potential climate-related changes to hurricane activity. The recent devasting wildfire events in California, while heartbreaking disasters for those affected, have also provided vital datapoints to help test and improve the existing wildfire models.
While the risk of some ILS investments can be accurately estimated therefore, the key is knowing whether this is being paid ‘on market’. In order to do this a security should not be considered on a standalone basis, but in the context of a broader portfolio in order to assess how its risk is adjusted by diversification. Only then can one judge whether the marginal impact of risk on a portfolio is being adequately rewarded. Our proprietary CatAPM® system helps us to maintain market perspective and aims to capture opportunistic returns in order to produce the optimal risk-reward for our portfolios.
Other methods at our disposal include using post-event satellite images of a large number of individual properties in order to expedite the process of estimating insured losses; this proved useful in the aftermath of Hurricane Michael, which made landfall in Panama City, Florida in October 2018, and during the November 2018 California wildfires, in helping to assess the potential impact on our portfolios.
The catastrophe events of 2017 and 2018 highlighted not only the mismatch between the capital of the (re)insurance industry and the forecast losses from potentially larger natural catastrophe events that could happen in the future, but also the large discrepancy between economic and insured losses when disasters occur. Even in the US, the most developed insurance market in the world, only 20% of households affected by flooding from Hurricane Harvey in 2017 had flood insurance11, for example, and less than 30% of the economic losses of Hurricane Florence in 2018 were insured12 . As economies continue to grow, and as concerns about a changing climate increase, the gap between insurance needs and available capital will amplify further. Without reducing this global gap, the financial burden of recovery and rebuilding from these disasters will be borne by the governments, businesses and ultimately by individuals.
ILS represent a valuable and growing source of structural capital to this world problem, helping to protect the homes and livelihoods of people around the world and building more disaster-resilient societies. In return for accepting a share of the disaster gap solution, we believe investors can have a measurable beneficial impact on the quality of people’s lives, while potentially generating attractive risk-adjusted returns with the added benefit of genuine diversification from more traditional return sources.