As environmental, social and governance principles become more prominent in guiding investment strategies, the ILS market must respond In recent years, there has been a sharper focus by the investment community on responsible investment. One indicator of this has been the increased adoption of the Principles for Responsible Investment (PRI), as environmental, social and governance (ESG) concerns become a more prominent influencer of investment strategies. Investment houses are also seeking closer alignment between their ESG practices and the United Nations’ Sustainable Development Goals (SDGs). The 17 interconnected SDGs, set in 2015, are a call to action to end poverty, achieve peace and prosperity for all, and create a sustainable society by 2030. As investors target more demonstrable outcomes from their investment practices, is there a possible opportunity for the insurance-linked securities (ILS) market to grow, given the potential societal capital that insurance can generate? “Insurance certainly has all of the hallmarks of an ESG-compatible investment opportunity,” believes Charlotte Acton, director of capital and resilience solutions at RMS. “It has the potential to promote resilience through enabling broader access and uptake of appropriate affordable financial protection and reducing the protection gap; supporting faster and more efficient responses to disasters; and incentivizing mitigation and resilient building practices pre- and post-event.” RMS has been collaborating on numerous initiatives designed to further the role of insurance and insurance technologies in disaster and climate-change resilience. These include exploring ways to monetize the dividends of resilience to incentivize resilient building, using catastrophe models to quantify the benefits of resilience investments such as flood defenses, and earthquake retrofit programs for housing. The work has also involved designing innovative parametric structures to provide rapid post-disaster liquidity. “Investors will want a clear understanding of the exposure or assets that are being protected and whether they are ESG-friendly” Charlotte Acton RMS “ILS offers a clear route for investors to engage with insurance,” explains Acton, “broadening the capital pool that supports insurance is critical as it facilitates the expansion of insurance to new regions and allows the industry to absorb increasingly large losses from growing threats such as climate change.” Viewed as a force for social good, it can certainly be argued that insurance-linked securities supports a number of the U.N.’s SDGs, including reducing the human impact of disasters and creating more sustainable cities, increasing overall resilience levels and increasing access to financial services that enhance sustainable growth potential. While there is opportunity for ILS to play a large part in ESG, the specific role of ILS within PRI is still being determined. According to LGT Capital Partners ESG Report 2019, managers in the ILS space have, in general, yet to start “actively integrating ESG into their investment strategies,” adding that across the ILS asset class “there is still little agreement on how ESG considerations should be applied. However, there is movement in this area. For example, the Bermuda Stock Exchange, a primary exchange for ILS issuers, recently launched an ESG initiative in line with the World Federation of Exchanges’ Sustainability Principles, stating that ESG was a priority in 2019 “with the aim to empower sustainable and responsible growth for its member companies, listings and the wider community.” For ILS to become a key investment option for ESG-focused investors, it must be able to demonstrate its sustainability credentials clearly. “Investors will want a clear understanding of the exposure or assets that are being protected,” Acton explains, “and whether they are ESG-friendly. They will want to know whether the protection offered provides significant societal benefits. If the ILS market can factor ESG considerations into its approach more effectively, then there is no reason why it should not attract greater attention from responsible investors.”
With innovation in the flood market increasing, EXPOSURE explores whether high-definition (HD) flood models are one of the keys to closing the protection gap In August 2017, Hurricane Harvey brought the highest level of rainfall associated with a tropical cyclone in the U.S. since records began, causing catastrophic flooding in some of the most populated areas of the Texas coast, including Houston. The percentage of losses attributed to inland flood versus wind damage was significant, altering the historical view that precipitation resulting from a tropical storm or hurricane is an attritional loss and highlighting the need for stochastic modeling. Total economic losses resulting from Harvey were around US$85 billion and insured losses were US$30 billion, revealing a significant protection gap, particularly where inland flood damage was concerned. Around 200,000 homes were inundated by the floods, and yet 80 percent of homes in the Houston area were uninsured. Hurricane Harvey Impacts – Aftermath An innovative catastrophe bond has suggested one way this protection gap could be reduced in the future, particularly as a private flood insurance market develops in the U.S. FloodSmart Re, which was announced at the end of July 2018, secured US$500 million of reinsurance protection on behalf of FEMA’s National Flood Insurance Program (NFIP). Reinsurer Hannover Re was acting as the ceding reinsurer for the transaction, sitting between the NFIP and its Bermuda-based special purpose insurer. “It’s a landmark transaction — the first time in history that the U.S. federal government is sponsoring a catastrophe bond,” says John Seo, co-founder and managing principal at Fermat Capital. “It’s just tremendous and I couldn’t be more excited. Events like Harvey are going to accelerate the development of the flood market in terms of risk transfer to the insurance-linked securities (ILS) market. “You have to have more efficient risk pooling and risk sharing mechanisms,” he adds. “There’s over US$200 trillion dollars of capital in the world, so there’s obviously enough to efficiently absorb event risk. So, it’s about, how do you get it out into that larger capital base in an efficient way?” While the bond only provides cover for flooding arising from named storms, either due to storm surge or rainfall, it is a “good test case for the ILS market’s appetite for flood risks,” according to ILS blog Artemis. While “it is not a broad flood coverage, it will likely help to make it more palatable to cat bond investors given their comfort with modeling the probability of named storms, tropical storms and hurricanes.” According to Cory Anger, global head of ILS origination and structuring at GC Securities, the ILS market is certainly showing an appetite for flood risk — including inland flood risk — with several catastrophe bonds completed during 2017 for European flood risk (Generali’s Lion II), Japanese flood risk (MSI and ADI’s Akibare Series 2018-1 Notes) and U.S. flood risk. “Both public and private sector entities see value from utilizing capital markets’ capacity to manage flood risk,” she says. “We think there are other geographic regions that would be interested in ILS capacity that haven’t yet tapped the ILS markets. Given the recent success of FEMA/NFIP’s FloodSmart Re Series 2018-1 Notes, we expect FEMA/NFIP to continue to utilize ILS capacity (along with traditional reinsurance capital) to support future U.S. flood risk transfer opportunities.” The ILS sector has grown significantly over the past 15 years, with deals becoming more complex and innovative over time. Many market commentators feel the market was put to the test following the major natural catastrophe losses in 2017. Not only did bonds pay out where they were triggered, fresh capital re-entered, demonstrating investors’ confidence in the sector and its products. “I’m hearing people starting to coin the phrase that 2018 is the ‘great reload,’” says Seo. “This is something I have been saying for quite some years: That the traditional hard-soft, soft-hard market cycle is over. It’s not that you can’t have an event so large that it doesn’t impact the market, but when it comes to capital markets, high yields are actually a siren call for capital. “I don’t think anyone doubts that had 2017 occurred in the absence of the ILS market it would have been a completely different story, and we would have had a traditional hard market scenario in 2018,” he adds. FloodSmart Re has clearly demonstrated the strong investor interest in such transactions. According to Anger, GC Securities acted as the structuring agent for the transaction and was one of two book runners. More than 35 capital markets investors provided fully collateralized protection to FEMA/NFIP on the landmark catastrophe bond. “The appetite for new perils is generally strong, so there’s always strong interest when new risks are brought to market,” says Ben Brookes, managing director of capital and resilience solutions at RMS. He thinks improvements in the underlying data quality along with high-definition flood models make it more likely that inland flood could be included as a peril in future catastrophe bond issuances on behalf of private insurers, on an indemnity basis. “In the early days of the cat bond market, new perils would typically be issued with parametric triggers, because investors were skeptical that sufficient data quality was achieved or that the indemnity risks were adequately captured by cat models. But that changed as investor comfort grew, and a lot of capital entered the market and you saw all these deals becoming indemnity. Increased comfort with risk modeling was a big part of that.” The innovative Blue Wings catastrophe bond, which covered insurer Allianz for severe U.K. flood risk (and some U.S. and Canadian quake) and was completed in 2007, is a good example. The parametric bond used an index to calculate flood depths at over 50 locations across the U.K., was ahead of its time and is the only U.K. flood catastrophe bond that has come to market. According to Anger, as models have become more robust for flood risk — whether due to tropical cyclone (storm surge and excess precipitation) or inland flooding (other than from tropical cyclone) — the investor base has been open to trigger selection (e.g., indemnity or parametric). “In general, insurers are preferring indemnity-triggered solutions,” she adds, “which the ILS market has concurrently been open to. Additionally, for this peril, the ILS community has been open to per occurrence and annual aggregate structures, which gives flexibility to sponsors to incorporate ILS capital in their risk transfer programs.” As the private market develops, cat bond sponsors from the insurance market would be more likely to bundle inland flood risk in with other perils, thinks Charlotte Acton, director of capital and resilience solutions at RMS. “A degree of hurricane-induced inland flood risk is already present on a non-modeled basis within some transactions in the market,” she says. “And Harvey illustrates the value in comprehensive modeling of flooding associated with named storms. “So, for a broader portfolio, in most cases, inland flood would be one piece of the picture as it will be exposed to multiple perils. However, a stand-alone inland flood bond is possible for a public sector or corporate sponsor that has specific exposure to flood risk.” With inland flood, as with all other perils, sophisticated models help to make markets. “A fund would look at the risk in and of itself in the deal, but of course they’d also want to understand the price and returns perspective as well,” says Brookes. “Models play into that quite heavily. You can’t price a bond well, and understand the returns of a bond, unless you understand the risk of it.” As the ILS market makes increasing use of indemnity protection through ultimate net loss (UNL) triggers, sophisticated HD flood modeling will be essential in order to transfer the peril to the capital markets. This allows clear parameters to be set around different hours clauses and deductible structures, for instance, in addition to modeling all causes of flood and the influence of local defenses. “It’s a landmark transaction — the first time in history that the U.S. Federal Government is sponsoring a catastrophe bond” John SEO Fermat capital Jillian Williams, chief underwriting officer at Leadenhall Capital Partners, notes that ILS is increasingly bundling together multiple perils in an effort to gain diversification. “Diversification is important for any investment strategy, as you are always trying to minimize the risk of losing large amounts in one go,” she says. “Cat bonds (144A’s) currently have defined perils, but collateralized reinsurance and private cat bonds can cover all perils. Complexities and flow of information to all parties will be a challenge for cat bonds to move from defined perils to UNL all perils. “Any new peril or structure in a cat bond will generate many questions, even if they don’t have a major impact on the potential losses,” she continues. “Investors will want to know why the issuers want to include these new perils and structures and how the associated risk is calculated. For UNL, all flood (not just sea surge) would be included in the cat bond, so the definition of the peril, its complexities, variables and its correlation to other perils will need to be evaluated and represented in the flood models used.” She thinks the potential to transfer more flood to the capital markets is there, but that the complexity of the peril are challenges that need to be overcome, particularly in the U.S. “Flood coverage is already starting to move into the capital markets, but there are many issues that need to be worked through before it can be moved to a 144A transaction in a UNL format for many territories,” says Williams. “Just one of the complexities is that flood risk may be covered by government pools. “To move flood perils from government pools to private insurers is like any evolution, it can take time, particularly if existing coverage is subsidized,” she adds. “For private insurers, the complexity is not just about flood modeling but also about ensuring risk-adequate pricing and navigating through government legislation.”
EXPOSURE investigates how traditional reinsurers, recognizing that third-party capital provides an opportunity rather than a threat, are opting to build or buy their own insurance-linked securities (ILS) fund management capabilities. The property catastrophe reinsurance industry has undergone a rapid transformation over the past decade as capital from institutional investors has flooded into the sector. Attracted by solid returns and an asset class that is uncorrelated to their other investments, investors steadily increased their allocations to ILS. At the same time as the resulting demand for product has intensified, collateralized reinsurance has overtaken catastrophe bonds as the dominant source of ILS capacity. As this institutional capital flooded into the peak zones of Florida wind, California earthquake and Japanese wind and earthquake, traditional reinsurers initially felt displaced. Excess capital, several years of benign catastrophe losses and differing risk and return appetites among the so-called “alternative” capital has heightened competition and eroded rates-on-line. 2015 saw a 3.5 percent reduction in traditional capital dedicated to reinsurance, down US$13 billion to US$357 billion according to Willis Re, reflecting the challenging operating environment and record volume of M&A activity among other drivers. The reduction was offset by the continued growth in non-traditional capital, which hit new heights of US$70 billion. Opportunity or Threat? Capital Growth for Dedicated ILS Funds and Reinsurer Third-Party Capital Managers More progressive reinsurance companies recognize this non-traditional capital is here to stay and the opportunities it presents if properly harnessed. While dedicated ILS funds still dominate the market in terms of assets under management, in recent years more reinsurers have sought to leverage these opportunities, setting up their own dedicated ILS funds, sidecars or special purpose syndicates to offer cedants a broader array of risk transfer tools while tapping third-party capital. Aspen, Everest Re, Hannover Re and Munich Re were among those who significantly increased sidecar capital earlier in 2016; there was also marked growth in managed fund capacity by Hiscox (Kiskadee Re), Validus Re (AlphaCat) and Lancashire (Kinesis) among others. Some have sought to access third-party capital by investing in existing players, with Leadenhall’s increased stake in Amlin, Markel’s acquisition of CATCo and Endurance’s acquisition of Blue Capital (as part of its acquisition of Montpelier Re), as recent examples. Managed fund capacity arguably combines the best underwriting with the most efficient forms of capital in the markets where it is deployed. The collateralized reinsurance platforms have access to the track record, underwriting expertise and catastrophe modeling and analytics know-how of the parent company, while the parent company gains access to considerable capital not held within its own balance sheet. Reinsurers are also able to target different business through their third-party management capabilities. Generally, pure ILS funds prefer “cleaner”, modelable business, whereas a traditional reinsurance company has access to the whole market. However, a reinsurer-owned fund is able to leverage the parent company’s existing infrastructure, access to business and its suite of risk management and pricing tools in order to offer something that is different from some of the independent ILS funds. Third-Party Reinsurance Capital Volume ($B) This is attractive to investors, particularly those looking to diversify away from property catastrophe peak perils into other classes of business. One trend for the collateralized reinsurance market is its growth outwards, both by territory and line of business. The ability to apply catastrophe models and exposure management tools in this bid for diversification is becoming a key differentiator for ILS funds. “THE ABILITY TO APPLY CATASTROPHE MODELS AND EXPOSURE MANAGEMENT TOOLS IN THIS BID FOR DIVERSIFICATION IS BECOMING A KEY DIFFERENTIATOR FOR ILS FUNDS.” Lancashire’s Kinesis Capital, for instance, has been set up as a multi-class, fully collateralized reinsurance provider covering specialty classes such as marine among its product offerings, albeit backed by a strong analytical approach. And the trend looks set to continue. In April 2016, ILS publication Artemis noted that the launch of the RMS® Marine Cargo and Specie catastrophe risk model would provide an enhanced approach to marine risk quantification, helping ILS investors and capital to increase participation in the marine insurance and reinsurance market. There are signs that some of the independent funds are recognizing the great benefit of having in-house catastrophe modeling and analytics capabilities, opting to license reinsurance catastrophe models or hire reinsurance talent from markets such as Lloyd’s and Bermuda to bolster their offerings. The boundary between the traditional reinsurance market and ILS arena will continue to blur in the coming years as market players seek to combine the best underwriting – and modeling and analytics expertise – with the most efficient form of capital.