This is a reprint of a “Trading Room” interview from Trading Risk magazine, please click here to visit the magazine website.
Opportunities abound for investors willing to embrace the resilience gap, according to RMS global managing director Daniel Stander
How does the Protection Gap offer opportunities for investors?
I’m afraid you’ve pushed one of my buttons with your very first question! I’ve been trying (unsuccessfully it seems) to move the debate away from the “protection gap”. I much prefer to talk about the “resilience gap”. This isn’t me being a pedant. The language we use here is important. Framing the problem in terms of “protection” grounds the debate in risk-transfer solutions.
But we all know that risk capital alone cannot address the fact that communities all over the world are frequently brought to their knees by the impacts of extreme events. Risk financing is no silver bullet. Those at risk — from the individual homeowner to the elected official governing a sovereign state — need much more than just contingent capital to materially increase their resilience to acute shocks. They need to develop a deeper understanding of the risks they face — and how it compares to their desired ability to withstand extremes.
More than that, they need to understand what interventions offer an acceptable ROI — from enforcing building codes to preserving nature-based defenses. And then of course they need to be prepared to respond effectively when the ground shakes or the wind blows, lest the economic impacts escalate. Opportunities abound for investors – but they will only be seized by those who can embrace the totality of the “resilience gap” and position their risk capital in the totality of the need.
What new innovations are on the horizon?
Innovations come when sellers find new ways to profitably help buyers solve their problems. When it comes to insurance-linked securities (ILS), experience has taught me that models make markets. Why? Well, market demand for an emerging type of coverage is often left unmet because the capital cannot be deployed with sufficient confidence.
The right analytics remove enough of that uncertainty to enable buyers and sellers to meet. It’s no coincidence, for example, that surge risk had never been securitized until RMS released a storm surge model. So, you ask me where I see innovation coming. Many of the answers can be found in our product road map: flood, cyber, marine, liability — a suite of high-definition models which will enable innovations in ILS.
What scope is there for the establishment of social development ILS funds?
We are increasingly involved in discussions as to the societal benefit of parametric ILS. There is a lot of innovation afoot, especially in terms of linking risk financing to investments in risk reduction. These conversations are increasingly joined up, involving fund managers, end investors, donor governments, recipient nations and venture philanthropists. I don’t think it will be long before we see an ILS impact fund set up that is motivated less by profit and more by a desire to increase the resilience of less developed communities.
Where is the role for ILS in international development?
Disasters in developing countries roll back years of hard-won economic gains. Parametric ILS can support the recovery efforts with rapid and transparent access to large pools of capital in the aftermath of disaster. But this is just one of the tools available. ILS must be considered alongside investments in disaster preparedness, risk mitigation, such as resilient building practices, and other financing instruments. 2017 highlighted that natural disasters can cause losses which dwarf a country’s entire GDP.
View of damage caused by Hurricane Irma in Road Town, the capital of the British Virgin Islands, taken on September 13, 2017. Image credit: Flickr/DFID – Russell Watkins
Against this backdrop, Lloyd’s and RMS have partnered with the U.K. government Department for International Development, to explore the potential for innovative financial products to incentivize resilience. Could parametric products help get core services like education and health up and running more quickly? Would having cover in place build institutional capability around risk management? Can risk transfer incentivize better building practices? There’s still much to be done, but these ongoing efforts can only accelerate the development of a viable, resilience-linked product.
Why were RMS annual average losses reduced ahead of the active hurricane season?
The medium-term rate (MTR) is a regionalized average for the next five years. It looks at the impact of projected sea-surface temperatures (SSTs) in order to determine where along the coastline, and at what strength, hurricanes are likely make landfall. The 2017 MTR stated a) that there would be fewer hurricanes, and b) that the energy provided by warm SSTs may lead to stronger-than-average hurricanes that drive tail risk. So, the 2017 North Atlantic hurricane season largely fitted with our model.
The MTR is grounded in objective science. We follow a systematic process each time we update it. We analyze 13 different statistical models, which all provide a five-year forecast of activity for the Atlantic basin, and we take a weighted average across these models based on their relative “skill”. The most statistically skillful of these models identified a shift to a future period of below-average hurricane activity, in part based on the 2012-16 decrease in Atlantic Basin major hurricanes.
What keeps you up at night?
I’m often asked this. People seem to assume that I lie awake at night fretting over all the really bad things that could befall humankind. The reality, however, is that working at RMS affords a better-than-average sense of perspective, especially when it comes to the probabilities of nasty extremes.
In fact, I’m often struck by how influenced people are by the latest news headline. This week might all be about cyberterrorism. Next week it’s an outbreak of a lethal virus. And the week after it’s earthquake risk. The truth is, the relativity between the frequency/severity distributions of different potential shocks is pretty constant. That’s arguably one of the virtues of a stochastic approach: a long-term view that helps keep things in perspective — during the day and at bedtime!