Category Archives: Capital Markets

EXPOSURE Magazine Snapshots: Water Security – Managing the Next Financial Shock

This is a taster of an article published by RMS in the second edition of EXPOSURE magazine.  Click here and download your full copy now.

18 Apr 2017 Exposure Drought image

 

EXPOSURE magazine reported on how a pilot project to stress test banks’ exposure to drought could hold the key to future economic resilience, as recognition grows that environmental stress testing is a crucial instrument to ensure a sustainable financial system.

In May 2016, the Natural Capital Finance Alliance (NCFA), which is made up of the Global Canopy Programme (GCP) and the United Nations Environment Programme Finance Initiative, teamed up with Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH Emerging Markets Dialogue on Finance (EMDF) and several leading financial institutions to launch a project to pilot scenario modeling.

Funded by the German Federal Ministry for Economic Cooperation and Development (BMZ), RMS was appointed to develop a first of-its-kind drought model. The aim is to help financial institutions and wider economies become more resilient to extreme droughts, as Yannick Motz, head of the emerging markets dialogue on finance, GIZ, explains.

“GIZ has been working with financial institutions and regulators from G20 economies to integrate environmental indicators into lending and investment decisions, product development and risk management.”

But Why Drought?

Drought is a significant potential source of shock to the global financial system. There is a common misconception that sustained lack of water is primarily a problem for agriculture and food production, but in Europe alone, an estimated 40 percent of total water extraction is used for industry and energy production, such as cooling in power plants, and 15 percent for public water supply.

Motz adds “Particularly in the past few years, we have experienced a growing awareness in the financial sector for climate-related risks.  The lack of practicable methodologies and tools that adequately quantify, price and assess such risks, however, still impedes financial institutions in fully addressing and integrating them into their decision-making processes.

“Striving to contribute to filling this gap, GIZ and NCFA initiated this pilot project with the objective to develop an open-source tool that allows banks to assess the potential impact of drought events on the performance of their corporate loan portfolio.”

Defining the Problem

Stephen Moss, director, capital markets at RMS, and RMS scientist Dr. Navin Peiris explain how drought affects the global economy and how a drought stress-test will help build resilience for financial institutions:

Water Availability Links Every Industry:  Stephen Moss believes practically every industry in the world has some reliance on water availability in some shape or form.  “With environmental impacts become more frequent and severe, there is a growing awareness that water as a key future resource is starting to become more acute.” adds Moss.

“So, the questions are, do we understand how a lack of water could impact specific industries and how that could then flow down the line to all the industrial activities that rely on the availability of water? And then how does that impact on the broader economy?”

Interconnected World:  Dr. Navin Peiris acknowledges that the highly-interconnected world we live in means the impact of drought on one industry sector or one geographic region can have a material impact on adjacent industries or regions, whether those adjacent are impacted by that phenomenon or not. This interconnectivity is at the heart of why a hazard such as drought could become a major systemic threat for the global financial system.

“You could have an event or drought occurring in the U.S. and any reduction in production of goods and services could impact global supply chains and draw in other regions due to the fact the world is so interconnected.” comments Peiris.

Encouraging Water Conservation Behaviors:  The ability to model how drought is likely to impact banks’ loan default rates will enable financial institutions to accurately measure and control the risk. By adjusting their own risk management practices there should be a positive knock-on effect that ripples down if banks are motivated to encourage better water conservation behaviors amongst their corporate borrowers, explains Moss.

“Similar to how an insurance company incorporates the risk of having to payout on a large natural event, a bank should also be incorporating that into their overall risk assessment of a corporate when providing a loan – and including that incremental element in the pricing.” he says. “And just as insureds are motivated to defend themselves against flood or to put sprinklers in the factories in return for a lower premium, if you could provide financial incentives to borrowers through lower loan costs, businesses would then be encouraged to improve their resilience to water shortage.”

Read the full article in EXPOSURE to find out more about the new drought stress-test.

 

Stephen Moss: Modeling Drought Reveals Surprising Range of Impacts
Stephen Moss, director, capital markets at RMS, said droughts affect far more than agriculture and can affect financial portfolios and supply chains. Moss spoke with A.M. BestTV at the Exceedance 2017 conference.

 

Updates from RMS on Major Hurricane Matthew

Monday, October 10

Matthew has now made its exit and work begins on the RMS loss estimate

By Tom Sabbatelli, RMS hurricane risk expert

Although it may be too soon to define Hurricane Matthew’s legacy, it will surely be remembered for keeping the insurance industry on tenterhooks for a few days. Having eschewed the U-turn that had been anticipated by many forecast models, Matthew adopted post-tropical characteristics early on Sunday morning, while tracking due eastward off the North Carolina coast. With Matthew’s exit, the fears of another blow to the regions that had already been hit hard by its first impact were put to bed.

So now we have initiated the next phase of RMS Event Response operations, with our attention shifting from the regular, reactive stochastic event selections to a comprehensive interrogation of all causes of loss – both modeled and unmodeled. It is this work that will form the basis of the RMS official  industry loss estimate.

Our vulnerability modelers, who make up our reconnaissance teams for Matthew, are on their way to southeast U.S. and The Bahamas. The team traveling to the southeast U.S. are likely to find the damage there is less severe than many forecasters feared prior to landfall. The fact that the storm stayed offshore for so long undoubtedly helped to reduce the potential losses across the region. Nonetheless, Matthew’s high moisture content and slow movement up the coast has caused significant and widespread flooding, driven by a powerful combination of heavy rainfall, historic wave heights, and significant storm surge.

Observations from Jacksonville, Florida and Charleston, South Carolina, as the storm passed over each city, revealed record-setting precipitable water levels.  Supported by this unprecedented atmospheric moisture, Matthew produced rainfall totals in excess of one foot in many areas, including up to 15 inches of rain in Cumberland County, North Carolina.

Here the antecedent conditions were already at their peak even before the storm, due to recent heavy rain events that had deluged the region. The combination of rivers in the area already near flood stage level and the already heavily saturated soils, produced an increased susceptibility for each nuanced type of surface flooding to occur.

The antecedent conditions are essential inputs to defining the flood waters associated with this event.

While the damageable surge and wave will make up a large proportion of our modeled flood hazard, the modeled impacts of the inland flooding will be difficult to fully differentiate until our reconnaissance team have collated more observational data. Some features of this event such as dam breakage are considered a non-modeled component of this event, despite their ongoing impacts to the damage still occurring in the area.

Commercial Versus Residential Losses

RMS expects that the losses to commercial lines will be the primary driver of total flood insured losses, predominately through multi-peril or all-risks policies. We expect that the contribution to insured losses by residential claims will be limited because a proportion of the residential property losses will be covered by the National Flood Insurance Program (NFIP).

As of July 31, 2016, there were approximately 417,000 NFIP policies in-force in Georgia, South Carolina, and North Carolina. Penetration of NFIP coverage varies significantly by distance to the coastline. In coastal regions it can be as high as 25 per cent in some areas, while inland participation can be less than 1 percent.  This means that although much of the storm surge-driven coastal flood losses will be covered to some extent by the NFIP, many flood-related losses further inland are expected to be uninsured.

Damage and Loss in the Caribbean

Although Matthew’s strongest winds stayed offshore in the U.S., which is likely to limit economic and insured losses, the same cannot be said for parts of the Caribbean, notably Haiti, Cuba, and The Bahamas. The RMS reconnaissance team visiting The Bahamas expect to see damage caused by high winds, storm surge, and record rainfall.

Based on reports and observation data to-date, storm surge and rainfall-induced flooding will likely drive damage in The Bahamas and other parts of the Caribbean, such as Cuba and Haiti – although for Haitians, obviously, the main concern at the moment is the terrible loss of life. Insurance penetration rates in The Bahamas are lower than those of the U.S.; however, the RMS reconnaissance team will be paying particular attention to the hard-hit islands of New Providence and Grand Bahama, home to approximately 85 per cent of the country’s insured exposure.

Calculating the RMS Loss Estimate

The insights gleaned from our reconnaissance trips will prove extremely valuable in complementing our work towards developing an industry loss estimate.

As the Event Response team now transitions from producing real-time event updates, the instrumental observations of wind and flood depth measurements they will continue to gather in the coming days will be fed into the reconstruction of Matthew’s wind and storm surge footprints. And the thorough investigation into Matthew’s damage begins as we aim to provide the insurance industry with a comprehensive review of Hurricane Matthew’s impact.

(end of Monday update 1)

 

Saturday, October 8

Today’s RMS response to Hurricane Matthew

By Ben Brookes, head of the RMS capital markets team; Emily Paterson, head of RMS event response; Dr Paul Wilson, RMS expert in hurricane and storm surge risk.

All times in this post are London, England

06:45 –

It’s not been often in the last 10 years that any of us have needed to set a Saturday morning alarm to catch the early National Hurricane Center (NHC) advisory for a powerful storm close to land.   Thankfully, we’ve had a long streak of no major hurricanes hitting the U.S., so it’s something of a blast from the past to be back in major hurricane response mode over a weekend!

A minute or two of hitting the f5 key, and the latest is in. While the loss of life in Haiti is sobering reminder of the power of these storms, it seems the drought of major Florida landfalls continues: Matthew has continued to “stalk” the Florida coastline as the more dramatic headlines report, but it has not come ashore in the state.  The track has taken it further north overnight, as anticipated, and now all eyes are on whether Matthew might have become the first land-falling hurricane in Georgia since the late 1800s

09:30

As hurricane modelers gather in the office this morning, many of whom look like they may not have been home, but revitalized by a large tray of coffees, the storm appears to be coming ashore in South Carolina. But it’s going to need a clearer picture of the inner structure of the storm before we know for sure.  As yet the NHC is not reporting a landfall, but the Hwind snapshots should give us clarity soon.   Whether we see a landfall next week after a loop back around is also the source of much debate.  And a point of interest for the industry too – will this be one loss or two?  (See yesterday’s Q&A further down this blog thread for more on this).

Our collective task this morning is to update our stochastic selection – choosing scenarios from the model that continue to represent the range of possible outcomes from Matthew, to help our clients understand the range of possible outcomes for their businesses.  Once again, we’re not attempting to estimate the industry loss that this storm has caused (or more accurately, is continuing to cause), that process will begin when the storm has passed, and we can gather and collect all possible data sets, and perform detailed reconnaissance of the areas impacted, both remote and in person.  RMS reconnaissance has already begun, with our remote sensing experts in full swing, and a team of our modelers headed to the affected region.  On the ground inspections and observations will need to wait until the storm has passed, including any looping around that might be to come.

We begin by looking at the NHC track and cone of uncertainty, and define “gates” for each point along the track and the projected path.  The set of candidate tracks is then any that pass through these same gates, with wind speeds within a defined range of the values reported by the NHC in each case.  We assemble a big list of candidate scenarios, and begin to review each one in turn, discussing the pros and cons of inclusion in our selection for the day.

This morning’s NHC Advisory

This morning’s NHC Advisory

First up is the Caribbean update. Even though Matthew has been out of the Bahamas for the best part of 24 hours, new information is available. Our Caribbean selection can now benefit from the work the RMS Hwind team is doing to generate a complete wind swath for Matthew.  The preliminary swath proves hugely useful to make sure we don’t include modeled events with winds too far east in our set.   As this work continues, it will inform our complete track selection for Matthew’s impact in the US as well. Remember to keep an eye on the @Hwind Twitter feed for rolling updates.

We spend some time debating the fact that our Caribbean track selection representing loss in the Bahamas contains numerous modeled events that do go on to cause a major disaster in Florida (and hence why these tracks do not represent what is happening in Florida) – the high pressure over the Carolinas that has steered Matthew along its unusual path has averted something far worse.

11:00

Our Caribbean scenarios are finalized, with a candidate set of 29 narrowed down to 13, the smallest modeled scenario at less than $1bn, and the largest just over $5bn (wind only).

We move on to discussing the ongoing situation in the U.S.  An hour of healthy debate ensues, and from our candidate set of 20 modeled storms with U.S. impact, we settle on five that our hurricane experts feel are Matthew-like, each in different ways: track similarity, parameter similarity (Vmax, Rmax, pressure), windfield similarity, onshore impact, and various other dimensions.

Our five modeled storm scenarios range from $2bn to $8bn (wind only) – considerable uncertainty remains.  It is however becoming clear that Florida at least has dodged the bullet that was heading its way on Thursday.

And as we always advise our clients, these are potential scenario losses, they represent a wide range consistent with the ongoing uncertainty, and they are not industry loss estimates of the storm itself.  An industry loss estimate will be provided as fast as possible, but requires much more interrogation of many more data sources, as well as sifting through all the damage and reconnaissance reports.

Hwind preliminary Caribbean footprint for the portion of track from Haiti into the Southern Bahamas.  Note the highest wind gust marker, on the South coast of Haiti, consistent with the reports of extreme damage now emerging.

Hwind preliminary Caribbean footprint for the portion of track from Haiti into the Southern Bahamas.  Note the highest wind gust marker, on the South coast of Haiti, consistent with the reports of extreme damage now emerging.

12:30

So, with today’s event selection complete, our team shifts gears again to package up the event selections to deliver to our clients via the RMS Event Response outreach process, with all associated insights and commentary.  We’re already receiving inbound requests from our clients, asking when this information will be made available – looks like lunch might have to get cold – time and (storm) tide wait for no modeler!

(end of Saturday update 1)

Friday, October 7 – update 2

1800 UTC

As Hurricane Matthew continues up the Florida coast, we’ve been putting some questions to RMS experts:

Q: Florida’s facing wind damage and flooding from rain and sea storm surges – which is likely to be worst?

RMS Meteorolgists and hurricane risk experts Tom Sabbatelli and Jeff Waters

“The potential for significant wind impact is decreasing, as Matthew has remained further offshore than anticipated and the strongest winds remain tightly packed around its center. However, forecasts have the storm coming close the Georgia/South Carolina coast. The principle concern turns to the north for significant flood risk in the southeast U.S., including high storm surge risk from Jacksonville northward to Charleston, SC. As a large, slow moving storm, Matthew has been absorbing a lot of tropical moisture and building up a lot of rising water over its lifecycle. This increases the potential for heavy rainfall and significant build-up of water along the southeast coastline, which features greater storm surge potential than eastern Florida due to local bathymetry (contours of the sea bed). The size and extent of storm surge-driven coastal flooding could be worsened as it phases with the normal, daily high tide.  Rainfall estimates in excess of one foot (30 cm) are expected along the coast of South and North Carolina, two areas where soils are already heavily saturated and river levels are high based on significant rainfall over the last few weeks.”

Q: How should insurers expect losses to be split between commercial and personal lines?

Tom Sabbatelli and Jeff Waters again:

“If Matthew ultimately turns out to be a flood-driven event, the insurance industry is more likely to be impacted by private commercial flood policies than residential flood, which is primarily covered by the National Flood Insurance Program (NFIP). Florida has the highest number of NFIP policies in-force (1.7 million), but there are only approximately 417,000 NFIP policies in-force combined for Georgia, South Carolina, and North Carolina.  In residential areas where both wind and storm surge have occurred, we do expect some degree of what we call “coverage leakage,” a claim’s adjuster’s inability to distinguish whether damage was caused by wind or storm surge. This effect tends to increase wind policy losses, as the flood loss “leaks” into the wind payout.”

Q: What causes most damage – the hurricane making landfall or tracking up the coast?

Brian Owens, RMS expert in tropical cyclones

“This depends on a number of factors – if Matthew were to make landfall as a major hurricane and track across Florida you could get significant damage; making landfall would weaken the storm but the core of the strongest winds would definitely pass over land. If the storm tracks the coast and the eye remains offshore this would cause Matthew to maintain its intensity as it has continuing access to its primary source of energy – warm sea water. The critical factors in this second scenario are how close to the shore Matthew tracks, for how long, and how far the strongest winds extend out from the centre of Matthew. What makes Matthew particularly unusual is that it is forecast to track along the coast of four states (FL, GA, SC and NC) as a hurricane. This could accumulate damage along hundreds of miles of coastal property.”

Dr Mike Kozar, expert in hurricane risk at the RMS Hwind high definition hurricane mapping center in Florida, adds:

“The center of Hurricane Matthew has remained just offshore this morning. Based on measurements from the Hurricane Hunter aircraft, peak winds were estimated to be around 115mph at 1200 UTC. These peak winds, are found on the northeastern eyewall, approximately 40km northeast of the center. So right now it looks unlikely that the strongest part of Matthew’s wind field will come ashore in Florida, although by definition hurricanes are extremely dynamic phenomena. However, the western eyewall, and with it hurricane force winds, is located just offshore, and wind gusts have already exceed 50mph along Florida’s Space Coast.”

Q: Hurricane Nicole is having an effect – how – and is it strange that we’re seeing two cyclones in the same area at once?

Brian Owens, RMS expert in tropical cyclones

“While unusual, this has been seen before in the tropical Atlantic. Hurricanes have large atmospheric circulations and when hurricanes are close those circulations can move around each other, interfere with each other, or even merge.”

Q: Matthew is a relatively small hurricane in terms of its surface area – does this have implications for its strength and intensity?

Brian Owens, RMS expert in tropical cyclones

“There are no set rules here: you can have large intense storms and smaller intense storms too. The core of the strongest winds is generally in a small area around the eye wall. Matthew has been through its lifetime on the smaller end of size range, which has implications for the geographic scale of the damaging winds and rain. It was very intense and destructive as it tracked through the Caribbean, and while weaker now, we need to remember that, regardless of size, Matthew will potentially impact a lot of coastal regions of the U.S.”

 

Western eyewall continues to skirt Florida coastline as Hurricane Matthew pushes northward. Peak winds still near 115mph well offshore.

(end of Friday update 2)

Friday, October 7 – update 1

1000 UTC

As Hurricane Matthew has developed we’ve been keeping you up to date all week with insights from RMS experts. As the storm moves up the Florida coast, here’s the latest:

Emily Paterson, head of RMS event response

“According to the 06:00 UTC National Hurricane Center (NHC) advisory, Matthew is currently impacting Florida as a Category 3 storm, with tropical storm force winds impacting Miami and south east Florida through last night. Matthew has started to accelerate and its closest approach is forecast for Cape Canaveral at 12:00 UTC. Although the NHC does not forecast a direct landfall at this time hurricane-force winds are expected to be felt along the East Coast.

Hurricane Matthew is forecast to continue to track extremely close to Florida and Georgia through Friday as it moves towards the north-northeast. The storm is forecast to weaken Friday night into Saturday while moving along the U.S. southeast coast, impacting portions of Georgia, South Carolina, and North Carolina.”

Ben Brookes, head of RMS capital markets team on the possible impacts

“Having strengthened to category four status on its approach to Florida, Matthew has now weakened again but there is still significant risk to communities in its path – hence the evacuations.

It’s still a highly dynamic situation – Matthew could yet take a more easterly path, and bypass the U.S. without major areas of hurricane force winds over land – yet even in this scenario, high winds, heavy rainfall, and a large storm surge are all possible and expected. A small difference in storm track, perhaps only in the tens of miles, could bring the center of the storm on land and significantly change the storm’s impact on Florida and the southeast U.S..”

Brian Owens, RMS expert in tropical meteorology commented on the weakening of Matthew:

“From radar you can see the eyewall became more disorganised as it left the Bahamas and moved towards the coast of Florida. This was consistent with the weakening of the storm back to Cat 3 overnight. The NHC has discussed that the hurricane may be going through an eye-wall replacement cycle, which typically leads first to a weakening of the storm, followed by possible further strengthening.”

Dr Paul Wilson, expert in hurricane risk added an update on the storm surge

“Should Matthew continue to track parallel to the east coast of Florida, catastrophic damage from storm surge is less likely than a similar-sized event in the Gulf of Mexico, because the bathymetry (contours of the sea bed) off the east coast of Florida is at a steep gradient, falling away quickly. However, Matthew’s size and speed, two very important factors in determining the expected amount of surge, will ultimately influence the amount of coastal flooding. It looks like there’s a possibility Matthew might be speeding up which would reduce the risk of prolonged winds causing damage along the coast.

In some areas, Florida’s east coast contains densely populated bays and rivers that may sit at greater risk to storm surge. If winds become aligned with the orientation of a bay or river over a period of hours, it can cause the water to pile up at the end of the waterway.”

(end of Friday update 1)

Thursday, October 6 – update 3

1430 UTC

As well as monitoring the likely impacts on Florida, RMS is also analyzing the continuing impacts on the Caribbean. Dr. Paul Wilson is an expert in hurricane and storm surge risk:

 “Today there’s understandably a lot of focus on how Matthew’s going to affect the U.S. But it’s still having major impact on the Bahamas.

Some commentators have been looking for historical comparisons and Hurricane Hazel in 1954 was a remarkable analogue for Matthew’s track across Haiti and Cuba. But Hazel passed through the Bahamas further to the east. A better analogue for Matthew’s current track in the Bahamas would be a storm like the 1899 San Ciriaco Hurricane which tracked further to the west.

Against today’s exposure RMS modeling would put Hazel at under US$1 billion in the Bahamas primarily from storm surge damages, while the San Ciriaco Hurricane would have been in excess of $5bn in the Bahamas. The range of losses from the pre-landfall analyses that RMS has made for Matthew encompass this range of historical loss.”

(end of Thursday update 3)

Thursday, October 6 – update 2

 1330 UTC

Dr. Mark Powell and Dr. Mike Kozar are RMS hurricane risk specialists based in Florida. Mark pioneered Hwind real-time analysis of hurricanes with observational data from instruments in the air, in the sea and on land – including aircraft reconnaissance, GPS dropsonde instruments, sea buoys and satellites. As the storm heads towards Florida, here is Mark and Mike’s latest take on Matthew, in light of the current forecast:

 “Given that Matthew’s strongest winds are confined to a very small area within its inner core, a difference of track in the tens of miles would translate to a substantial change in wind impacts both along the coastline and in interior cities such as Orlando.

Currently, landfall is most likely to occur between, West Palm Beach and St. Augustine early Friday morning. Winds will likely approach and possibly exceed hurricane force across much of this stretch of coastline, with localized flooding from storm surge, and heavy rainfall. The storm will gradually weaken as it remains very close to if not over land for much of Thursday night and Friday.

Nonetheless, other parts of the state will see effects too. Although hurricane force winds may be confined to coastal areas, torrential downpours and wind gusts will likely stretch across more than half of the peninsula as the storm progresses northward. On Friday night, Matthew is expected to continue north of this area approaching Jacksonville, as it slowly starts to curve back towards the northeast, roughly following the shape of the coastline in Georgia and South Carolina. Eventually on Saturday a subtropical ridge to the north will force Matthew to turn to the east, and potentially southeast, away from the coast into a more hostile environment that will cause Matthew to weaken more rapidly.”

(end of Thursday update 2)

Thursday, October 6 – update 1

Good morning. We’ve been asking experts from across RMS for their observations as Hurricane Matthew develops.

At 1100 UTC on Thursday 6 October, this is the first of today’s updates, from the RMS event response team:

Major Hurricane Matthew is forecast to continue tracking through the Bahamas on Thursday while intensifying from a Category 3 to a Category 4 hurricane.

At this stage there’s not complete agreement between forecasts on whether there’ll be a direct landfall in Florida, but the all projections indicate that impacts in the state could be significant. Currently, the National Hurricane Center (NHC) forecasts Matthew to track up the east coast within 30 miles (48km) of the shore with a closest approach of under 5 miles (8km) from land at Cape Canaveral.  Whilst, the Global Forecasting System (GFS) and European Centre for Medium-Range Weather Forecasts (ECMWF) indicate a potential landfall somewhere between Port St. Lucie and Cape Canaveral.

It’s also set to get stronger, developing from a Cat 3 to a Cat 4 storm as it tracks towards Florida. Hurricane force winds are expected to extend 45-60 miles (75-95 km) north of the eye, which could therefore affect the entire Florida coast as the system tracks alongside it. According to the NHC, there is a greater than 40% chance of hurricane force winds affecting the coast between Boca Raton and Daytona Beach and a greater than 80% chance of tropical storm winds affecting the entire east coast of Florida north of Miami.

Both the GFS and ECMWF expect Hurricane Matthew to make a southward turn early on Sunday October 9. There is some disagreement between the forecasts for Matthew’s track into next week; GFS indicates that Matthew may make a westward turn with a potential second landfall in Florida whilst the ECMWF has the storm remaining in the Atlantic before moving out eastwards by Wednesday next week.

U.S. Tropical storm warnings are now in effect for the Florida Keys and Florida Bay whilst hurricane warnings are in place for the entire east coast north of Miami. Hurricane watches are also now in effect for the entire coast of Georgia and parts of South Carolina.

(end of Thursday update 1)

Wednesday, October 5 – update 2

We’ve been asking experts from across RMS for their observations as they monitor the progress of Hurricane Matthew. This is the second update for today – please read further down this thread for the first.

At 1600 UTC on Wednesday, here’s the latest commentary:

Emily Paterson – head of RMS event response – on the current forecast:

“Matthew is expected to track through the Bahamas as a Category 4 storm through tomorrow, Thursday October 6, before tracking 45 miles (72 km) offshore parallel to the Florida coastline on Friday October 7. A Florida landfall as a Category 3 or 4 storm is possible under the current forecast, with the interaction with Tropical Storm Nicole and a mid to upper level high pushing Matthew further west. There are large amounts of insured exposure along the eastern Florida coast, which have the potential to be impacted by the storm.”

Tom Sabbatelli – RMS meteorologist and hurricane risk modeler – on the characteristics of Hurricane Matthew

“While its cloud structure may appear symmetrical, a hurricane does not feature a symmetrical wind field. In the northern hemisphere the portion of a hurricane to the right of its track typically features the strongest winds and storm surge. While still a powerful hurricane, Florida is expected to not fall within Matthew’s right hand side, as the current forecast track parallels its east coast.

If current forecasts turn out to be accurate, a movement along Florida’s east coast would make catastrophic damage from sea storm surge less likely because the east coast is ocean-facing and shelves off deeply. If it was a more gentle sloping coastal incline, like on the Gulf of Mexico, this would allow larger surges to build up. However, we are still intently watching the evolution of Matthew’s size and speed, two very important factors in determining the expected amount of surge.”

On this point, Dr Mark Powell – RMS hurricane and storm surge risk specialist – added

“The exception to this could be the densely populated bays and rivers along the East Coast. Examples would include Biscayne Bay, which extends north and south of Miami, the Indian River Lagoon system that comprises 30% of Florida’s central east coast, the Halifax River near Daytona Beach,  and the St. Johns River near Jacksonville, which can be more vulnerable to storm surge especially for a slow moving storm like Matthew. If winds become aligned with the orientation of the bay/river over a period of hours, it can cause the water to pile up at the end of the bay.”

Ben Brookes – head of the capital markets team at RMS – has been continuing to assess the potential impact on catastrophe bonds and other insurance-linked securities:

“If anything, things are more uncertain today than they were yesterday – the range of forecasts seems to have widened, with everything from West Palm Beach landfall to a complete Florida bypass, or landfall in the Carolinas. There are even models predicting Matthew will make a loop in the Atlantic and further impact Florida next week.

Potential market impacts are therefore still very broad – if Matthew makes landfall in a densely populated area, or closely skirts the Florida coastline around Cape Canaveral through to Jacksonville, we could still be looking at losses that would rival anything in recent history. But that’s a big “if.” In a scenario like this, we could see the ILS market impacted, and with significant bond exposure in Florida, a major industry loss would be highly likely to also mean losses to outstanding cat bond principal.

On the other hand, it remains quite possible for Matthew to stay further offshore, or for the damaging winds to affect less populated areas.  As yet we could still be looking at a low-single-digit billions industry loss event, which would mean very little impact to the ILS market.

What’s clear is that the uncertainty that’s unfolding is likely to create trading interest – the market is closely monitoring what’s going on, and in some cases actively hedging.”

Aircraft data from NOAA Hurricane Hunter and the Hurricane Hunter Association indicates that western eyewall of Hurricane Matthew has weakened from its landfall in Cuba.

(END OF WEDNESDAY UPDATE 2)

Wednesday, October 5 – update 1

Latest update from Dr Mike Kozar and Dr Mark Powell, experts in hurricane risk based in Tallahassee, Florida – RMS’ center for HWind high definition hurricane impact mapping.

There was a possibility that Hurricane Matthew might have weakened yesterday as it travelled over Hispaniola, the large island comprised of Haiti and the Dominican Republic. But Matthew’s center only skirted Haiti’s mountainous terrain and quickly returned over water, and so its strength did not diminish much. The storm continued northward through the Windward Passage during the afternoon, maintaining its intensity between 130 mph and 140 mph according to measurements from the U. S. Air Force Reserve Hurricane Hunters.

The 0000 UTC Wednesday morning HWind analysis indicated that Matthew made landfall on the eastern tip of Cuba with hurricane force winds extending about 50 miles westward.  Matthew’s short time over land will limit the interaction with Cuba’s terrain so the storm is expected to regain intensity shortly after emerging back over the ocean near the southern Bahamas. The storm is expected to continue generally northward through the Bahamas on Wednesday before threatening the United States on Thursday and Friday.

In the last 24 hours, model consensus has shifted the effects of the storm westward, making impacts along the Southeast coast of the United States more likely.  As Matthew approaches Florida, the storm is expected to slowly weaken in the next day or two, owing to increased vertical wind shear. Overall, the threat to Florida, Georgia, and the Carolinas will be determined by the exact track of the storm, particularly how far west it reaches as it interacts with the subtropical ridge while moving northward up the coast.

The general model consensus suggests that Matthew will slide northward very near, if not scraping along, the Florida coastline as a strong hurricane, making at least tropical storm force winds, high surf, and heavy rain likely for most of the cities along Florida’s East Coast, which has not seen a direct landfall from a hurricane since Katrina in South Florida in August 2005 (Hurricane Wilma struck the Gulf coast in later in 2005 and more recently Hermine struck the panhandle earlier this year).

Beyond potential impacts to Florida, the forecast into the weekend is still quite uncertain, as the position and strength of the subtropical ridge will determine whether or not Matthew will continue up the coast or meander off of the Southeast coast before heading out to sea.

(END OF UPDATE)

Tuesday, October 4

Major Hurricane Matthew is one of the most powerful North Atlantic hurricanes in recent history, having briefly reached Category 5 strength on Saturday October 1 and the strongest hurricane anywhere in the Atlantic since Hurricane Felix in 2007, which also tracked through the Caribbean Sea.

Below we have expert commentary on the storm from Ben Brookes, Emily Paterson, and Dr. Michael Kozar, and we will be posting further updates here on the RMS Blog as the event unfolds over the next few days.

Ben Brookes, Vice President, Capital Markets at RMS, said: “There are a number of public catastrophe bonds exposed to Caribbean windstorm, the vast majority of which only have exposure in Puerto Rico. At this time Hurricane Matthew is far enough from Puerto Rico to be unlikely to cause a significant impact. There are no publicly issued catastrophe bonds on risk solely covering Caribbean exposures. If present, Caribbean exposure typically makes up a small proportion of exposed limit alongside U.S. and Canadian exposure.

NHC hurricane watches or warnings are in effect for Jamaica, Haiti, Turks and Caicos and certain regions of Cuba and the Bahamas, all of which except Cuba are member nations of the Caribbean Catastrophe Risk Insurance Facility (CCRIF). CCRIF provides insurance coverage on a parametric modeled loss basis to member countries and sponsored a catastrophe bond in 2014 issued from the World Bank’s Global Debt Issuance Facility alongside its traditional reinsurance program.”

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“Flooding and landslides are a big concern from Hurricane Matthew in the Caribbean, and are likely to be a major contributor to damage from the storm. The slow-moving nature of Matthew is allowing the storm to build up moisture, which can result in heavy rainfall as the system passes over land,” said Emily Paterson, head of event response at RMS.

While Matthew is still a Category 4 major hurricane, the wind-field is relatively small, with hurricane force winds only extending 40 miles (65 km) from the center. Matthew is making landfall along the edges of Haiti and Cuba, and therefore we expect wind damage to be relatively localized.

Storm surge from Matthew is another concern. Matthew’s strong winds can cause significant storm surge in the Caribbean. Many of the islands in Matthew’s track have multiple bays, which have the potential to amplify storm surge by not allowing the water to flow away to the side. Furthermore, as Matthew has a fairly linear track, this also amplifies the risk of high waves and storm surge. 

We are keeping a close eye on Matthew’s extended 4-5day forecast, which has the storm tracking very close to the U.S. coastline off Florida and the southeastern states, before making landfall in the U.S. in the Carolina region at Category 2 strength. There’s still a fair amount of uncertainty at this lead time though.”

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Dr. Michael Kozar, hurricane risk specialist at RMS, notes: “Matthew has a thermodynamic environment that could potentially support a very intense hurricane as it moves up the Gulf Stream over water with sea-surface temperatures of above 28°C.

With respect to the slow forward speed of Matthew, if a storm sits on top of its own cold wake it can weaken. However, in Matthew’s case, the sea surface temperatures across the northern Caribbean and around the Bahamas are well above 28°C. Furthermore, warm water seems to exist well below the surface, based on maps of various isotherm depths and ocean heat content. Given how shallow water is near the Caribbean Islands, upward mixing of cold water may not be a huge limiting factor on the storm’s intensity, until it pulls further north into colder waters or northeast off the continental shelf.

A more significant factor for a cap in Matthew’s intensity, besides the amount of time it spends near/over land such as Hispaniola and Cuba, is wind shear and dry air. Forecasting the impact of wind shear on Matthew has been quite tricky thus far as Matthew has been located just south of an area of moderate to high shear for quite some time. If the shear north of the system holds its ground, Matthew very likely will weaken.

Furthermore, there also appears to be some dry air in the mid-levels that could suppress intensity as Matthew pulls poleward away from the Caribbean and into the Western Atlantic. All of this does point to weakening as the storm moves northward, but keep in mind the model consensus has been calling for some degree of weakening for a day or two. Yet Matthew’s intensity largely just oscillated up and down over the course of the weekend and into today.

Regardless, the inner core of Matthew is quite small, so the large scale impacts from wind may be secondary to the impacts from rainfall, save for within about 50 miles of the center.”

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Based on RMS reconnaissance trips to the area in 2015 as part of the research conducted to update the RMS North Atlantic Hurricane Model in 2017, the RMS view of vulnerabilities by island is below: 

Haiti: In Haiti the main concern is rainfall, since with steep terrain much of the country is exposed to flooding and landslides which could be the biggest source of issues in the most populated areas if they aren’t hit by high winds. And certainly the most exposed areas along the southern coast look like they will be hit hard. It is expected that much of the local building stock has been built in recent years, following the 2010 earthquake that devastated the country. The Haitian government instituted a new building code in 2012, in direct response to the earthquake, but it is unclear to what extent this new building code is being enforced. RMS research does, however, indicate that buildings in Haiti are expected to perform worse than most Caribbean islands, although this varies by individual construction type. Insurance penetration in Haiti is expected to be low.

Cuba: While market knowledge of vulnerability in Cuba is low, research into the area by RMS shows us that, despite being older on average, the building stock performs well overall due to the high presence of concrete construction. Insurance penetration is also expected to be low.

Jamaica: Building codes in Jamaica have not had a major revision since the first building code was enacted in 1908. However, RMS reconnaissance and research shows that single-family homes are built by local engineers to high standards; reinforced concrete construction is very prevalent across the island. In 2012, Jamaican engineers adopted many practices outlined in recent International Building Code (IBC) standards, which are likely to be enacted in newer commercial construction.

Bahamas: Insurance Penetration in the Bahamas is understood to be higher than other Caribbean islands, although lower than hurricane-exposed regions of the U.S. However, RMS analysis suggests that the Bahamas, with a long history of building codes, exhibit better construction quality than most of the Caribbean. The predominant construction material is reinforced concrete, although amongst the Family Islands there is a higher proportion of wood construction, leaving these islands potentially more vulnerable to wind damage. Despite being well attached to the walls, roofs in the Bahamas often feature asphalt shingles, which can increase the vulnerability of the roof and the entire structure. RMS reconnaissance shows that insured property accounts for less than 40 percent of all homes; one estimate places single-family dwelling insurance penetration at near 20 percent. Commercial exposures are more likely to be insured than residential exposures.

Insurance-Linked Securities in Asia – Looking Out for the Tipping Point

We were at a conference in Singapore, pushing to develop a market that doesn’t yet really exist. Grounds, you might think, for frustration.

And yet my RMS capital markets colleague, Jin Shah, and I were upbeat and, in truth, a little excited.

So often we end up at ILS conferences talking to the same audiences about the same topics. But this was different. The inaugural ILS Asia Conference organized by Artemis.bm, the de facto bulletin-board for the ILS industry, had 170 industry experts and practitioners from the region gathered in the Raffles Hotel ballroom.

The aim of the event was to demonstrate the ILS industry’s commitment to building a global footprint and developing expertise in the asset class among Asia’s investors and reinsurers. This conference was exciting because we can see the Asia insurance industry will approach a tipping point in the next decade or so, resulting in increased appetite in Asian ILS instruments from both sides. Let me explain how.

An Insurance Market Which Has Not Yet Matured

Currently in many Asian countries, the insurance market is still developing and the concept of insurance as a social and economic “good” is still not culturally normalized. In addition, mandatory insurance outside of auto/motor is, in some places, almost non-existent, with individuals looking instinctively to family and other social networks to provide financial safety-net.

Because of these factors, combined with generally lower levels of disposable income, property insurance penetration, in particular, is comparatively low in Asia. Thus, the region only contributes a small amount to reinsurer’s portfolios and capital loads. So they don’t yet need to transfer some of that risk to the capital markets as is the case in core, concentrated regions such as the U.S., Japan, and Europe. The economics of ILS in Asia are challenging to say the least, and in some cases, make fully collateralized products “non-starters” from a competitive point of view.

Growing Populations and Changing Demographics

But that’s the current environment. The future growth of the middle classes, particularly in China and India, will fuel increasing demand for all forms of insurance as more people chose to protect their assets against damage and loss. Given the sheer size of the population and their rate of growth, it is not inconceivable that within ten years these markets could represent a similar level of risk concentration to (re)insurers as the U.S., Europe, or Japan.

And that’s the tipping point.

In certain Asian countries, the ILS sector is already developed. For a number of years, Australian insurers have been tapping the capital markets as a strategic element of their outwards protection. Japanese risk has been a core part of the risk available in both the cat bond and collateralized re markets. Outside of these more mature markets, last year China Re issued their Panda Re cat bond which, whilst only being a $50 million dip-of-a-toe in the water, showed that ILS funds were keen to accept China risk and pave the way for larger issuances in the future.

And with social, demographic and economic changes in the years ahead Asia will provide a natural hunting ground for ILS funds, keen to leverage their broad and diversified capital base to support the local insurance market’s continued growth.

Sensing this future tipping point too, the Artemis conference was attended by more than 25 industry stalwarts who’d travelled from London, Bermuda, New York, San Francisco, Japan, and Australia to bring the conversation to new audiences. ILS investors are clearly looking to this region to diversify their own portfolios, both as a risk management measure and with an eye to the rapid growth occurring in the region – and the opportunities it presents.

Your essential ILS overview at Exceedance

The Insurance Linked Securities (ILS) market is always fast-moving, changing, and evolving. Even in the last twelve months we have seen events such as the emergence of new market players and the increasing convergence between the capital and reinsurance markets, with all this supported by a wave of new innovations.

If you are involved in the ILS sector, want to get involved, or are just interested to find out more about the ILS market, join us at Exceedance. The RMS Capital Markets team has developed five sessions focused on ILS, from general overviews to expert-led panel discussions with respected leaders from the ILS sector.

A good starting point at Exceedance is our session on “Innovation in Risk Transfer,” as we look back at the last twelve months in the ILS sector. An interesting counterbalance has developed with investors looking for new ways to deploy capital, combined with the sector developing new solutions, to address gaps in coverage, infrastructure resiliency, and efficiency of protection.

If you want to hear directly from the market, we have put together an Exceedance panel of industry leaders from specialist ILS funds, rated reinsurers, and hybrid capital providers. Our panel discussion entitled “The Changing Face of Third-Party Capital” will examine pricing, competition, the role of analytics, and how new opportunities continue to drive innovation in an increasingly capital-agnostic sector.

There are also three sessions from our team designed to give you more of a detailed overview into specific ILS-related topics:

  • Bridging the Coverage Gap: ILS capital continues to flow into the industry, and our session will reveal how market participants are driving innovation by designing new types of structures using cutting-edge analytics. These innovations are addressing protection gaps in developed and emerging markets, with market innovation complimenting traditional coverage rather than competing with it.
  • Time Is Money: This session will focus on how new insurance products are being developed around novel triggers designed to permit rapid payment after a catastrophe, enabling hedging of time-sensitive risks.
  • Modeling the Risk and Return of Reinsurance: To address a market shift from cat bonds to more non-liquid reinsurance investments, our session will show how standardized model analytics can provide much-needed consistency in the view of risk, asset valuation, and expected returns.

Join us at Exceedance.

Clearing the path for catastrophe bond issuance

Cat bond efficiency has come a long way in the last decade. The premature grey hair and portly reflection that peers back at me in the mirror serves as a reminder of a time when even the simplest deals seemed to take months of work.  A whole thriving food delivery industry grew up in the City of London just to keep us fed and watered back when success was measured on capacity to work a 120-hour week, as much as on quantitative ability.

Much has changed since then. Of course, complex ground-breaking deals still take a monumental amount of effort to place successfully—just ask anyone who’s been involved with Metrocat, PennUnion or Bosphorus, and they’ll tell you it’s a very intensive process.

But there’s little doubt that deal issuance has streamlined remarkably. It is now feasible to get a simple deal done in a matter of a few short weeks, and the market knows what to expect in the way of portfolio disclosure and risk analysis information. Indeed, collateralized reinsurance trades have pushed things further, removing some of the more complex structural obstacles to get risk into insurance linked securities (ILS) portfolios efficiently.

This week, I was on a panel at the Securities Industry and Financial Markets Association (SIFMA) Insurance and Risk Linked Securities Conference, discussing the ways in which the efficiency of the cat bond risk analysis could be further streamlined. This topic comes up a lot—a risk analysis can be one of the largest costs associated with a transaction (behind the structuring fees!), and certainly a major component of the time and effort involved.

If there’s one aspect we can all agree on, I suspect it’s the importance of understanding the risk in a deal, and how that deal might behave in different catastrophic scenarios. Commoditizing the risk analysis into a cookie-cutter view of a few well-known metrics is not the way to go—every portfolio is unique, and requires detailed, bespoke understanding if you’re to include it in a well performing ILS portfolio.

Going further, it is often suggested that the risk analysis could be removed from cat bonds—indeed, there’s no other asset class out there where the deal documents themselves contain an expertized risk analysis. Investors are increasingly sophisticated—many can now consume reinsurance submissions and have the infrastructure to analyze these in-house. The argument goes, why not let the investors do the risk analysis, and take it out of the deal—that way the deal can be issued more efficiently. One deal—Compass re II—has tested this hypothesis via the Rewire platform, and successfully placed with a tight spread.

Compass was parametric—this meant that disclosure was complete. The index was fully described, so investors (or their chosen modeling consultancy) could easily generate a view of risk for the deal.  This would not have been so straightforward for an indemnity deal—here, as an investor, you’d probably want to know the detailed contents of the portfolio in order to run catastrophe models appropriately. Aggregates won’t cut it if you don’t have a risk analysis.  So, for this to work with indemnity deals, disclosure would have to increase significantly.

An indemnity deal with no risk analysis would also open up the question of interpretation—even if all the detailed data were to be shared, how should the inuring reinsurance structures be interpreted?

This can be one of the most time consuming elements of even the simplest indemnity deals.  Passing this task on to the market rather than providing the risk analysis in the deal would inevitably lead to a change in the dynamic of deal marketing—suddenly investors would be competing more and more on the speed of their internal quoting process, and be required to develop large modeling infrastructure, far larger than most ILS funds currently have access to today.  Inevitably this would take longer and lead to a more uncertain marketing process.  Inevitably it must load cost into the system, which might well be passed back to issuers by way of spread or to end investors by way of management fees. Or both. Suddenly the cost saving in the bond structure doesn’t look as attractive.

I believe there’s a better alternative—and it’s already starting to happen. Increasingly, we are being engaged by potential deal sponsors much earlier in their planning process, often before they’ve even contemplated potential cat bond structures in detail. In this paradigm, the risk analysis can be largely done and dusted before the bond issuance process begins—of course, it’s fine-tuned throughout the discussions relating to bond structures, layers and triggers etc. But the bulk of the work is done, and the deal can happen efficiently, knowing precisely how the underlying risk will look as the deal comes together. This leads to much more effective bond execution, but doesn’t open up the many challenges associated with risk analysis removal.

Detailed understanding of risk, delivered in the bond documentation, but with analysis performed ahead of the deal timeline. Perhaps the catastrophe bond analysts of the future won’t have to suffer the ignominy of receiving Grecian 2000 for their 30th birthdays.

Ben and the RMS capital markets team will be talking more about innovation in the ILS market at Exceedance 2016– sign up today to join us in Miami

The ILS Community Is Calling Out for Greater Pricing Transparency

I often hear reinsurance underwriters comment on how difficult it is to capture and represent all of the risks underlying a single transaction. Their data comes in many different formats, sometimes from broker or cedants’ own models, which can result in significant differences in modelling assumptions from one transaction to the next. Alongside this, deals almost always include some unmodeled risks like terrorism, aviation or marine. Consolidating all the risks in a transaction into a single view can be frustratingly complex.

This was a tolerable situation in the world of traditional reinsurance, when an underwriter’s autonomy and experience carried greater weight, and capital providers—usually shareholders—were less interested in the finer details of the risks. But the world has changed. Today, as collateralized reinsurance and sidecars financed by highly technical investors become increasingly widespread, especially in retrocession markets, better quality data is more important than ever, and often essential to getting the deal done.

Furthermore, the Insurance Linked Securities (ILS) market demands valuation of its on-risk investments, as fund managers face increasing pressure from stakeholders (internal compliance, regulators, and especially investors) to have deals marked independently.

The challenges

The challenge is compounded by capital markets investors’ broadening appetite for reinsurance risk. Both excess of loss layers and quota share deals are in the frame, with the former often covering tail risk with a low probability of attachment, and the latter the full distribution of risks with a high frequency of loss that’s attritional in nature. Deal pricing is fundamentally dependent on the transaction structure. Attachment and exhaustion probabilities determine the likelihood that event losses will trigger and exhaust a layer, and ultimately how losses within a layer will develop over a risk period. Because of this, a time-dependent view of loss development and ‘incurred but not reported’ claims should influence investment valuations. Historically, this has proved difficult to achieve, given the inconsistent data and unmodeled risks typically supplied in a deal submission. Current market solutions employed by fund managers are mainly based on actuarial methods of valuation which do not capture the full risk profile.

Cash flow is also critical. Net earned premium should be risk weighted to ensure that future premium cash flow is not accrued before the risk has passed. Set-up costs including brokerage fees, taxes, and others should also be considered. Lastly, pricing models must be dynamic, such that the technical price is updated to reflect actual reported losses, and cash flow forecasts are recalibrated accordingly.

Such a view of risk and return – one which is both time and structure-dependent – is fundamental to arriving at the proper valuation of a reinsurance deal in isolation and, also critically, for a portfolio. A uniform procedure for transaction and outstanding deal pricing is therefore crucial to satisfying investors and their stakeholders.

We can now achieve all of that easily, regardless of the state of the risk information in hand.

RMS’ Miu platform offers a single environment in which to analyse all risks within a transaction, with a new multi-model risk aggregation feature complimented by a pricing service. The simulation-based tool delivers a single, holistic view of the risk in a proposed or live transaction and provides complete portfolio roll-up capabilities. In addition, the RMS mark-to-model pricing service provides weekly marks to support net present value calculations for deals, portfolios, and fund of fund strategies.

The solution

By using the RMS Miu platform, investors and reinsurers can import loss data in multiple formats, including exceedance probability (EP) curves, results data modules (RDMs), and event loss tables (ELTs), and fold them into a single, comprehensive view of risk. It’s an easy process which can be done while maintaining correlations between peril regions, whether the risk is modeled by RMS or not, capturing correlation of non-modeled risks across deals by defining a baseline view of risk for specific peril regions.

The Miu applications enable investors and reinsurers to unify their universe of risk into one place. More broadly, the platform facilitates their ability to model and share ILS reinsurance transactions by providing a single view of risk, in so doing delivering the market transparency that leads to improved pricing certainty, and consequently more capital for the sector.

This post was co-authored by Anaïs Katz and Jinal Shah. 

Anaïs Katz

Analyst, Capital Market Solutions, RMS
As a member of the advisory team within capital market solutions, Anaïs works on producing capital markets’ deal commentary and expert risk analysis. Based in Hoboken, she provides transaction characterizations to clients for bonds across the market and supports the deal team in modeling transactions. She has woked on notable deals for clients such as Tradewynd Re and Golden State Re. Anaïs has also helped to model and develop her group’s internal collateralized insurance pricing model that provides mark to market prices for private transactions. Anaïs holds a BA in physics from New York University and an MSc in Theoretical Systems Biology and Bioinformatics from Imperial College London.

Cat Bond Pricing: Calculating the True Rewards

Commentary in the specialist insurance press has generally deemed pricing of catastrophe bonds in 2015 to have bottomed out. While true in average terms, baseline pricing figures mask risk-return values. True risk pricing can be calculated only by considering all dimensions of loss, including seasonal variations and the time value of money. New analysis by RMS does just that, and shows that cat bond pricing has actually been higher in 2015 than it was last year.

Pricing of individual cat bonds is based largely on the expected loss—the average amount of principal an investor can expect to lose in the year ahead. Risk modelers calculate the expected loss for each deal as part of the transaction structuring, but to obtain a market-wide view based on consistent assumptions, we first applied the same model across all transactions to calculate the average expected loss.

Care must be taken as all loss is not equal, a fact reflected in the secondary-market pricing of catastrophe bonds. Because of the time value of money, a loss six months from now is preferable to a loss today: you can invest the money you are yet to lose, and collect coupons in the meantime. We have calculated the time-valued expected loss across more than 130 issuances in the secondary markets, which we have called Cat Cost. It is dramatically different than unadjusted values, as shown in Figure 1.

The next step to reveal the true level of cat bond pricing involves accounting for secondary market pricing quotes. Figure 2 plots the same Cat Cost data as Figure 1, but now includes pricing quotes of the bonds, which we gleaned from Swiss Re’s weekly pricing sheets. Also plotted is the “Z-spread”—this is the spread earned if all future cash flows are paid in full and the metric is calculated using a proprietary cash flow model which determines future cash flows (floating and fixed), and discounts back to the current market price. The difference between the two—the space between the top and bottom lines—is the Cat-Adjusted Spread, which measures the expected catastrophe risk-adjusted return.

We can see clearly that on 30 September, 2014 the Cat Cost was 1.53%, identical to the Cat Cost on the same day in 2015. However, this year’s cat-adjusted spread for that day is 2.52%, compared to 2.22% for 2014. In other words, the pricing of cat bonds at the end of the third quarter of 2015 was thirty basis points higher than it was on the same date in in 2014, relative to the risk and adjusted for the time value of money.

The astute will have noticed that the bond spread rises each year as the hurricane season approaches, and falls as it wanes. To account for this seasonal pricing effect, and to reveal the underlying changes in market pricing, we have split the analysis between bonds covering U.S. hurricanes and those covering U.S. earthquakes.

The findings are plotted in Figure 3, and the picture is again dramatic. It is clear that the price of non-seasonal earthquake bonds is relatively static, while hurricane bond prices rise and fall based on the time of year.

      

This analysis further shows—for both hurricane and earthquake bonds—that spreads were higher this year than last, relative to adjusted risk. Steep drops in excess returns masked roughly static end-of-year returns in the cat bond market, rather than reflecting a risk-based price decline. Despite the prevailing commentary, the catastrophe bond market is returning markedly more to investors today than it did a year ago, when it bottomed out. But only accurate risk and return modeling reveals the true rewards.

This post is co-authored by Oliver Withers and Jinal Shah, CFA.

Jinal Shah

Director, Capital Markets, RMS
With more than 10 years of experience in the Insurance Linked Securities (ILS) market, Jin is responsible for managing investor relationships and new ILS product development at RMS. During his time at RMS, Jin has led analytical projects for catastrophe bond placements , and has designed new parametric indices to facilitate trading of index-based deals in peak zones, as well as introduced new pricing initiatives to the ILS market.

Jin currently focuses on pricing deals and managing portfolios with RMS ILS investor clients, and leads the development of Miu, the RMS ILS portfolio management platform. Jin holds a bachelor’s in Mathematics from The University of Manchester Institute of Science and Technology, and a master’s in Operational Research from Aston Business School and is a CFA charter holder.

What Can the Insurance Market Teach Banks About Stress Tests?

In the last eight years the national banks of Iceland, Ireland, and Cyprus have failed. Without government bailouts, the banking crisis of 2008 would also have destroyed major banks in the United Kingdom and United States.

Yet in more than 20 years, despite many significant events, every insurance company has been able to pay its claims following a catastrophe.

The stress tests used by banks since 1996 to manage their financial stability were clearly ineffective at helping them withstand the 2008 crisis. And many consider the new tests introduced each year in an attempt to prevent future financial crises to be inadequate.

In contrast, the insurance industry has been quietly using stress tests with effect since 1992.

Why Has the Insurance Industry Succeeded While Banks Continue to Fail?

For more than 400 years the insurance industry was effective at absorbing losses from catastrophes.

In 1988 everything changed.

The Piper Alpha oil platform exploded and Lloyd’s took most of the $1.9 billion loss. The following year Lloyd’s suffered again from Hurricane Hugo, the Loma Prieta earthquake, the Exxon Valdez oil spill, and decades of asbestos claims. Many syndicates collapsed and Lloyd’s itself almost ceased to exist. Three years later, in 1992, Hurricane Andrew slammed into southern Florida causing a record insurance loss of $16 billion. Eleven Florida insurers went under.

Since 1992, insurers have continued to endure record insured losses from catastrophic events, including the September 11, 2001 terrorist attacks on the World Trade Center ($40 billion), 2005 Hurricane Katrina ($60 billion—the largest insured loss to date), the 2011 Tohoku earthquake and tsunami ($40 billion), and 2012 Superstorm Sandy ($35 billion).

Despite the overall increase in the size of losses, insurers have still been able to pay claims, without a disastrous impact to their business.

So what changed after 1992?

Following Hurricane Andrew, A.M. Best required all U.S. insurance companies to report their modeled losses. In 1995, Lloyd’s introduced the Realistic Disaster Scenarios (RDS), a series of stress tests that today contains more than 20 different scenarios. The ten-page A.M. Best Supplemental Rating Questionnaire provides detailed requirements for reporting on all major types of loss potential, including cyber risk.

These requirements might appear to be a major imposition to insurance companies, restricting their ability to trade efficiently and creating additional costs. But this is not the case.

Why Are Stress Tests Working For Insurance Companies?

Unlike the banks, stress tests are at the core of how insurance companies operate. Insurers, regulators, and modeling firms collaborate to decide on suitable stress tests. The tests are based on the same risk models that are used by insurers to select and price insurance risks.

And above all, the risk models provide a common currency for trading and for regulation.

How Does This Compare With the Banking Industry? 

In 1996, the Basel Capital Accord allowed banks to run their own stress tests. But the 2008 financial crises proved that self-regulation would not work. So, in 2010, the Frank-Dodd Act was introduced in the U.S., followed by Basel II in Europe in 2012, passing authority to regulators to perform the stress tests on banks.

Each year, the regulators introduce new stress tests in an attempt to prevent future crises. These include scenarios such as a 25% decline in house prices, 60% drop in the stock market, and increases in unemployment.

Yet, these remain externally mandated requirements, detached from the day-to-day trading in the banks. Some industry participants criticize the tests for being too rigorous, others for not providing a broad enough measure of risk exposure.

What Lessons Can the Banking Industry Learn From Insurers?

The Bank of England is only a five-minute walk from Lloyd’s but the banking world seems to have a long journey ahead before managing risk is seen as a competitive advantage rather than an unwelcome overhead.

The banking industry needs to embrace stress tests as a valuable part of daily commercial decision-making. Externally imposed stress tests cannot continue to be treated as an unwelcome interference in the success of the business.

And ultimately, as the insurance industry has shown, collaboration between regulators and practitioners is the key to preventing financial failure.

New Risks in Our Interconnected World

Heraclitus taught us more than 2,500 years ago that the only constant is change. And one of the biggest changes in our lifetime is that everything is interconnected. Today, global business is about networks of connections continents apart.

In the past, insurers were called on to protect discrete things: homes, buildings and belongings. While that’s still very much the case, globalization and the rise of the information economy means we are also being called upon to protect things like trading relationships, digital assets, and intellectual property.

Technological progress has led to a seismic change in how we do business. There are many factors driving this change: the rise of new powers like China and India, individual attitudes and even the climate. However, globalization and technology aren’t just symbiotic bedfellows; they are the factor stimulating the greatest change in our societies and economies.

The number, size, and types of networks are growing and will continue to do so. Understanding globalization and modeling interconnectedness is, in my opinion, the key challenge for the next era of risk modeling. I will discuss examples that merit particular attention in future blogs, including:

  • Marine risks: More than 90% of the world’s trade is carried by sea. Seaborne trade has quadrupled in my lifetime and shows no sign of relenting. To manage cargo, hull, and the related marine sublines well, the industry needs to better understand the architecture and the behavior of the global shipping network.
  • Corporate and Government risks: Corporations and public entities are increasingly exposed to networked risks: physical, virtual or in between. The global supply chain, for example, is vulnerable to shocks and disruptions. There are no local events anymore. What can corporations and government entities do to better understand the risks presented by their relationships with critical third parties? What can the insurance industry and the capital markets do to provide CBI coverage responsibly?
  • Cyber risks: This is an area where interconnectedness is crucial.  More of the world’s GDP is tied up in digital networks than in cargo. As Dr. Gordon Woo often says, the cyber threat is persistent and universal. There are a million cyber attacks every minute. How can insurers awash with capital deploy it more confidently to meet a strong demand for cyber coverage?

Globalization is real, extreme, and relentless. Until the Industrial Revolution, the pace of change was very slow. Sure, empires rose and fell. Yes, natural disasters redefined the terrain.

But until relatively recently, virtually all the world’s population worked in agriculture—and only a tiny fraction of the global population were rulers, religious leaders or merchants. So, while the world may actually be less globalized than we perceive it to be, it is undeniable that it is much flatter than it was.

As the world continues to evolve and the megacities in Asia modernize, the risk transfer market could grow tenfold. As emerging economies shift away from a reliance on a government backstops towards a culture of looking to private market solutions, the amount of risk transferred will increase significantly. The question for the insurance industry is whether it is ready to seize the opportunity.

The number, size, and types of networks are growing and will only continue to do so. Protecting this new interconnected world is our biggest challenge—and the biggest opportunity to lead.

Exceedance 2015: In the Books

It’s been quite a week here in Miami – full of palm trees, ocean views…and catastrophe risk management.

Throughout the week, our keynote speakers discussed hot topics in science, catastrophe modeling, and risk management:

  • We kicked off the week with keynotes from Hemant Shah, Paul Wilson, Ben Brookes, and Daniel Stander discussing RMS’ vision for the future and how catastrophe modeling can enable innovation and growth within the (re)insurance industry and beyond.
  • Patricia Grossi shed light on earthquake risk in Latin America, and there were more than a few misty eyes as Laurence Golborne regaled us with tales of risk management from his time as minister of mines and energy in Chile, where he led the rescue of the “Los 33” miners trapped underground for more than two months.
  • Rick Knabb, director of the National Hurricane Center, explained why awareness is central to the mission of the NHC; educating the public about the need to prepare increases the ability to recover.
  • Robert Muir-Wood explained that the biggest concentrations of risk and gradients of risk are coastal, necessitating state-of-the-art modeling of storm surge, tsunami, and liquefaction in order to mitigate this risk.

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Hemant and other members of the RMS leadership team answered questions on-stage during an “Ask Us Anything” session. Here are a few highlights:

  • What’s your vision beyond 2020?
    • Eric Yau: We want to create an open platform that unlocks innovation potential for our clients and partners.
    • Matthew Grant: Our goal is to allow clients to underwrite business that isn’t possible today. We will work together to grow the broader (re)insurance market.
  • What can I do to help Nepal? 
    • Paul VanderMarck: We work with Build Change, an organization aligned with our mission of mitigating risk. We recommend them as an organization and are matching employee contributions. Build Change is starting a program in Nepal using the same playbook that has already been successful in areas such as Haiti and Japan.
  • Suppose you were to start from scratch today – would you do anything differently? 
    • Mohsen Rahnama: When we started, we didn’t have any of the tools we have today. We take advantage of and implement technology to approach problems in a systematic way. Technology allows us to build better models.

In addition, we were thankful to have many of our clients and partners not just attend, but present at Exceedance. BMS, JLT RE, Munich Re, Aon Benfield, Risk Frontiers, Holborn Corp, ARA, Willis Re, Guy Carpenter, TigerRisk, SCOR, and Price Forbes all presented during the “Alternative Views of the Market” track which provided insight from across the industry.

  • Munich Re showed impactful videos of homes under 100 mph winds, emphasizing the difference in performance of structures built to various standards.
  • Willis Re advocated for deterministic modeling and developing alternative views of risk by considering different sizes of events and “what if” analyses.
  • Guy Carpenter explained how to define critical events by aligning the level of loss to specific outcomes such as lost earnings, ratings watches, and ratings downgrades.

And finally, we salsa-ed the night away to the sweet tunes of two-time Grammy-nominated Latin band Palo during EP, the Exceedance Party, at LIV nightclub.

I hope you enjoyed the week and found it insightful and thought-provoking. We hope to see you all back at the Fontainebleau Miami Beach Hotel next year, where Exceedance 2016 will take place from May 16 to 19.