ILS Market Update. Index triggers: no panacea but still helpful. November 2018

Transcription

1 Index triggers: no panacea but still helpful November 2018

2 Q market perspective: Index triggers: no panacea but still helpful One constant in the ILS market going back nearly 25 years is the steady stream of cheerleaders claiming indextriggered ILS can unlock massive amounts of capacity, grow the alternative capital market and close the protection gap. Notwithstanding these claims, the market has largely moved away from rather than toward index triggers and in our view, will likely continue to do so. That being said, there remain some excellent use cases for index triggers. Most index triggers are in reality implemented as double triggers where a recovery only occurs if the index trigger is met and the cedant suffers actual losses as well. The primary potential drawbacks are poor design and basis risk. Definition and uses of index triggers Index triggers are based less on actual loss than on a proxy for actual loss. Proxies include industry loss indices based on PERILS or PCS figures, pure parametric or parametric index triggers, modeled loss triggers or hybrids, or population mortality and morbidity statistics. As a technical matter, most index triggers are in reality implemented as double triggers where a recovery only occurs if the index trigger is met and the cedant suffers actual losses as well. In that case, they are in fact contracts of indemnity and generally treated as reinsurance for legal and accounting purposes. Pros and cons Index triggers have various pros and cons. The primary advantages include enhanced speed of calculation and recovery, transparency and ease of understanding for all parties. These attributes can potentially save cedants money by accessing capital more efficiently. The primary potential drawbacks are poor design and basis risk. If not thoughtfully designed, index triggers can be more rather than less complex and slower rather than faster to determine. In fact, a poorly designed trigger can even enhance rather than mitigate dispute risk and make accurate modeling more rather than less difficult. Practically speaking, basis risk means a mismatch between expected recoveries and actual recoveries. It is not exclusive to index-triggered ILS deals. For example, the application of an exclusion or an hours clause in a reinsurance contract based primarily on actual losses can also result in a mismatch. 2

3 Q market perspective: Index triggers: no panacea but still helpful A shortfall can even risk cedant insolvency. The available premium or risk spread discount for index triggers has declined relative to indemnity triggers. Most risk managers and ceded reinsurance professionals care more about a shortfall in expected recoveries than in the potential for an over-recovery. A shortfall can even risk cedant insolvency. Basis risk can increase the required limit purchased for a given risk management objective thereby nullifying the discounted spread otherwise available for using an index. It is this trade-off between potential savings and basis risk that seems to drive most decisions for or against index triggers. Unbiased advice from intermediaries is very helpful here. General trend away from index triggers In practice, outside of retro, as the available premium or risk spread discount for index triggers has declined relative to indemnity triggers, the share of index trigger transactions has declined as evidenced by the market share trend illustrated below. Trends beyond the cat bond market are similar. This is a good news story. It reflects improved data, transparency, and understanding of indemnity risk rather than any inherent discomfort with index triggers. Year-end non-life capacity outstanding ($ billions): Evolving market share of indemnity and index triggers 2008 $ YTD $ % 40% 66% 60% Indemnity Index Index triggers remain important in some special situations. Some exceptions Notwithstanding the general trends and issues raised above, index triggers remain important in some special situations. First, index triggers remain common for retro, whether for cat bonds or ILWs. Second, where the underlying data quality is poor or the coverage is exceptionally difficult to model (e.g., business interruption for certain classes of business), the discount for an index trigger can rise considerably making an index trigger more attractive. Recent sovereign nat cat and extreme mortality ILS deals come to mind. Another example is Japan, where earthquake derivatives are popular with large corporates to hedge their risk. Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018. Aggregate data excludes private ILS deals. 3

4 Q market perspective: Index triggers: no panacea but still helpful Intermediaries also increasingly design relatively more refined and commoditized index triggers that both reduce basis risk and result in broad syndication achieving the best price. Outlook Some say that if index triggers drive down costs enough, they can reduce the protection gap substantially, notwithstanding the resulting basis risk. Theoretically, this is possible. The evidence thus far suggests a more limited benefit - as you have to deliver a product people will actually buy. Yes, index triggers can help close the gap, but they will not be transformative on their own. Wishful thinking cannot overcome math and economics. On a more optimistic note, the ability to measure and manage basis risk continues to improve. Intermediaries and other unbiased advisors work more and more with insureds and cedants to understand the trade-offs inherent in index triggers and to manage basis risk. Managing basis risk occurs, for example, through better overall design of a reinsurance program explicitly taking basis risk for a single index protection into account. Intermediaries also increasingly design relatively more refined and commoditized index triggers that both reduce basis risk and result in broad syndication achieving the best price. This design process prevents a handful of large self-interested reinsurers and ILS managers from foisting bespoke triggers on unsuspecting buyers, in which customization serves primarily to thwart competition and raise rates rather than to achieve any meaningful advantage for buyers. * * * * * In sum, as the insurance, reinsurance and ILS markets work together to solve new problems for insureds, index triggers are a very useful tool to consider. They may not on their own close the protection gap, dramatically grow the ILS market, or solve all cedant problems - far from it. Nevertheless, with creativity, unbiased advice and sustained effort, they can still have a meaningful impact. 4

5 Q ILS market issuance overview This recordbreaking Q3 issuance seems to put this year s $8.7 billion year-todate issuance on track to approach or even exceed last year s record of $9.7 billion. Kaiser Permanente returned to the cat bond market as a repeat corporate sponsor to access additional capacity through Acorn Re. The National Flood Insurance Program added to its relatively new private reinsurance program with its first cat bond capacity. The third quarter of 2018 saw five underwritten widely distributed non-life ILS issues totaling approximately $1.6 billion of capacity, surpassing Q s record of approximately $1.4 billion. This record-breaking Q3 issuance seems to put this year s $8.7 billion year-to-date issuance (as of Q3-end) on track to approach or even exceed last year s record of $9.7 billion. Of the roughly $1.6 billion issued this past quarter, $200 million will provide Peak Multiperil protection and $650 million will provide U.S. Earthquake protection. The remainder will cover new perils, with $500 million providing protection from Flood resulting from U.S. Wind and $200 million providing California Wildfire Liability protection. In Q3 2018, AXIS secured additional capacity through Northshore Re II. A key difference is that unlike prior Northshore Re deals, it will also provide protection against European Wind exposure in addition to the protection from U.S. Wind and U.S. Earthquake the prior deals provided. The tranche features an industry index trigger on an annual aggregate basis. It is also noteworthy that this tranche will feature a four-year term, up from three years in the prior series. The issue has an expected loss of 4.86% with a risk spread of 7.70% that fell below its initial guidance of 8.00% to 8.50%. The bond was upsized 33% from an initial guidance of $150 million to $200 million. Kaiser Permanente returned to the cat bond market as a repeat corporate sponsor to access additional capacity through Acorn Re as its 2015 series neared maturity. This tranche provides per occurrence protection from North American Earthquakes with a parametric trigger. Earthquake box locations lie along the West Coast of the U.S. and extend into parts of Sonora Mexico, British Columbia and the Pacific Ocean. The trigger has four levels based on severity of magnitude. Northern California contributes to more than 80% of the initial modeled expected loss of 0.80% (compared to an initial modeled expected loss of 0.74% for the 2015 series). The deal was initially marketed with a guidance of $300 million (the same size as the matured 2015 series) and upsized 33% to $400 million. This tranche priced with a risk spread of 2.75%, which is lower than the 3.40% for the 2015 series. Following substantial loses from 2017 named storm events, the National Flood Insurance Program (NFIP) added to its relatively new private reinsurance program with its first cat bond capacity via two tranches of notes issued through FloodSmart Re. The NFIP is a federal government-operated flood insurance program administered by the U.S. Federal Emergency Management Agency that was formed to sustain the availability of voluntary flood insurance. Historically, funding shortfalls that exceed premiums collected have been financed by the U.S. Treasury. In addition to featuring a first time sponsor, this transaction marks the first known cat bond issuance using KatRisk as modeling agent. KatRisk specializes in modeling flood and wind risk in the U.S. and Caribbean. The notes feature a three-year term providing indemnity protection on a per-occurrence basis. Both tranches upsized and priced at the bottom of initial guidance with the $325 million Class A tranche paying a risk spread of 11.25%, while the $175 million Class B tranche will pay 13.50%. 5

6 Q ILS market issuance overview Non-life Q ILS issuance (a) ($ in millions) Sponsor (b) Issuer/Tranche Issue Maturity Amount EL Spread Basis Risk Trigger CEA Ursa Re D Sep-18 Sep-21 $ % 5.10% Annual AGG U.S. Quake Indemnity PG&E Cal Phoenix Re A Aug-18 Aug % 7.50% Annual AGG California Wildfire Liability Indemnity NFIP FloodSmart Re A Jul-18 Aug % 11.25% OCC U.S. Wind Indemnity NFIP FloodSmart Re B Jul-18 Aug % 13.50% OCC U.S. Wind Indemnity Kaiser Permanente Acorn Re A Jul-18 Nov % 2.75% OCC U.S. Quake Parametric AXIS Northshore Re II A Jul-18 Jul % 7.70% Annual AGG Peak Multiperil Industry Index Q also featured a first time corporate sponsor, Pacific Gas and Electric, bringing a new peril to the cat bond market. Q3'18 Total: $1,550 Q also featured a first time corporate sponsor, Pacific Gas and Electric (PG&E), bringing a new peril to the cat bond market through Cal Phoenix Re. PG&E is a U.S. natural gas and electric energy company that provides service in Northern and Central California. Cal Phoenix Re will provide California Wildfire Liability protection for losses caused by power, transmission or distribution systems owned or operated by PG&E. This deal will feature a three-year term with an indemnity trigger on an annual aggregate basis and has embedded call options. With a modeled loss of 1.01%, the single tranche will pay a risk spread of 7.50%. It is worth noting that the 2017 Thomas Fire would have resulted in a total loss for this tranche. The California Earthquake Authority effectively renewed its Ursa Re B issue that matured on September 15, 2018, through Ursa Re D. The single $250 million layer will provide about three years of indemnity protection on an annual aggregate basis from California Earthquakes. The new deal features a 2.87% expected loss (modeled by EQECAT) and will pay a risk spread of 5.10% after being marketing with a range of 5.00% to 5.25%. Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018. Aggregate data exclude most private ILS deals. (a) All issuance amounts reported in or converted to USD on date of issuance. EL for HU deals is based on WSST conditioned catalog for AIR and medium-term catalog for RMS (b) If fronted, beneficiary listed if known 6

7 Interview: Matthew Ball Senior Director Insurance Consulting Technology and Global ILS Consulting practice How did you first get involved in the ILS space? Before coming to Bermuda in 2010, I worked in the London office for a number of years in the insurance actuarial consulting practice of one of the predecessor firms of Willis Towers Watson. It was there during the mid-2000s that I first got involved in a few alternative risk transfer projects, as the space was called at the time. These involved securitization of some pretty esoteric asset classes venture debt, pharmaceutical research and development and carbon credits where the structure included both insurance and capital markets solutions. These were challenging but very interesting projects. There was no standard actuarial playbook in terms of modeling these risks and certainly no standard vendor model so you had to go back to first principles. The loss activity over the last couple of years has certainly presented some challenges and opportunities Valuation of illiquid (level 3) assets has been one of the challenges. Matthew Ball Senior Director Insurance Consulting Technology and Global ILS Consulting practice at Willis Towers Watson After coming to Bermuda in 2010, to lead the Insurance Consulting and Technology (ICT) practice here, I naturally got involved in more traditional ILS projects given Bermuda s leading position as a reinsurance and ILS market, working for various stakeholders (ILS funds, sidecars, end investors, cedants and cat bonds) across various areas (valuation, governance reviews, pricing and portfolio management and software solutions). This involvement has grown over time, together with the growth in the ILS market, and a number of years ago I led the formation of the ILS Consulting practice within ICT to tailor our products and services to the needs of the ILS industry. What sort of work do you do with ILS investors (besides in cat bond transactions)? Has the loss activity the last few years presented any unique challenges or opportunities? How do you see things changing in light of what has transpired? Our ILS Consulting practice within ICT works with ILS funds and end investors providing advice, solutions and software to help clients manage risk and capital, improve business performance and create competitive advantage across a wide variety of situations including independent third-party valuation, pricing, financial modeling and operational due diligence reviews. The loss activity over the last couple of years has certainly presented some challenges and opportunities. We touched on a few of these aspects at a presentation we gave at the recent ILS Convergence conference in Bermuda earlier in October of this year. Valuation of illiquid (level 3) assets has been one of the challenges. Alternative reinsurance capital has grown from $23 billion at the end of 2011, the last year of significant loss activity before 2017, to $88 billion at the end of 2017; private ILS, such as collateralized reinsurance, has been a key driver of this growth. So valuation of these assets has become more important from an overall market perspective. 7

8 Interview: Matthew Ball Senior Director Insurance Consulting Technology and Global ILS Consulting practice The 2017 events were a reminder that valuation techniques need to adapt to the context. Currently, only a third of ILS funds are using independent third-party valuation for illiquid (level 3) assets. Good governance and transparency are grease for the wheels of operations within the ILS industry and will ultimately assist with faster growth. Given that ILS funds usually report NAVs on a monthly or more frequent basis, there can be estimation challenges early on after loss events. This was illustrated in the aftermath of Hurricane Maria, where there were estimates from two of the property cat model vendors with non-overlapping ranges. When cedant estimates started to come in, some initial cedant estimates were closer to the ultimate estimate than others. There is nothing particularly new in some of these issues. The 2017 events were a reminder that valuation techniques need to adapt to the context, for example, the type of event (e.g., hurricane, wildfire, earthquake), time after the event (e.g., use of exposure methods, claims development methods or a blend), local legal and claims environment (e.g., assignment of benefits and demand surge in Florida post-irma) and cedant valuation philosophy. Overall, we continue to see valuation practices improve over time. It is better than the Wild West we observed a few years back, but there is still work to do on improving some of the technical aspects (e.g., valuation of losses close to attachments points or aggregate excess of loss contracts), the operational efficiency of internal valuation processes post-event and governance and overall transparency. Currently, only a third of ILS funds are using independent third-party valuation for illiquid (level 3) assets (per Willis Towers Watson s recent ILS survey), although we have seen this demand increasing. In addition, we have seen a growing demand from ILS funds for our valuation technology and software solutions to improve operational efficiency. After the events of 2017, and with a growing desire for more transparency in the industry, we anticipate the governance demands from internal and external stakeholders will continue to increase. Funds that can demonstrate a more robust, transparent and efficient valuation process than their peers, all else being equal, should be able to assume more market share over time. Trapped collateral and liquidity have also proved challenging to market participants over the last couple of years. Despite the events of 2017 and the material amounts of trapped collateral, the market still managed to more than reload on January 1, Nonetheless, we did see an increase in questions from our clients around trapped collateral; for example: how much collateral was trapped and for how long? Should we move from more of a direct model to a fronting model? How can we improve the collateral release mechanisms? So the opportunity here is for the funds that can manage their collateral more efficiently and potentially a broader market opportunity to allocate capital to collateral release solutions. Also, there seems to be a general market desire to try to improve some of the underlying collateral release mechanism structures. If you could change one thing about the ILS market, what would it be and why? One particular area we focus on is helping clients improve the governance and transparency of their operations; for example, the loss reserve specialist and claims reviewer roles performed for cat bonds, or the third-party independent valuation agent roles performed for ILS funds, sidecars and end investors. The Standards Board for Alternative Investments is also pushing for greater transparency in the ILS space. Overall, the industry has progressed in recent years in terms of governance and transparency, yet there is still work to be done as discussed above. I would like to see this progress quicker. Good governance and transparency are grease for the wheels of operations within the ILS industry and will ultimately assist with faster growth as more and more investors become attracted to the ILS space. 8

9 Issued capacity/ capacity outstanding ILS Market Update Q ILS market statistics Par outstanding by risk peril 60% 55% 52% 50% 40% 30% 20% 14% 16% 11% 12% 8% 11% 8% 10% 3% 1% 4% 5% <1% 0% Q3'18 Q3'17 Total: $27.8 billion (a) Total: $25.5 billion (b) Par outstanding by expected loss at issuance 60% 50% 40% 30% 28% 28% 21% 22% 22% 22% 20% 13% 15% 16% 12% 10% 0% Q3'18 Q3'17 Total: $27.8 billion Total: $25.5 billion Peak Multiperil U.S. Wind U.S. Quake Japan Quake <0.75% 0.76% 1.50% 1.51% 2.50% Japan Wind Euro Wind Others Non-Life 2.51% 4.50% >4.51% Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018. (a) In aggregate, 66% of all capacity outstanding exposed to U.S. Wind. (b) In aggregate, 66% of all capacity outstanding exposed to U.S. Wind. Non-life ILS issuance by quarter ( ) (c) ($ in billions) $7.5 $ $ $4.0 $ $2.7 $2.0 $2.1 $2.1 $1.5 $1.7 $1.6 $1.2 $ $1.0 $0.7 $0.9 $0.3 $ Q1 Q2 Q3 Q4 Non-life capacity issued and outstanding by year (c) ($ in billions) Issued capacity Outstanding at year-end # of deals $1.3 $ $4.6 $8.4 $27.8 $25.5 $22.9 $22.5 $22.8 $18.7 $14.1 $15.2 $11.8 $12.3 $12.4 $12.7 $9.7 $7.2 $7.1 $8.0 $8.7 $4.8 $5.9 $6.2 $6.1 $2.7 $3.4 $ Number of deals YTD Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018. Aggregate data excludes private ILS deals. (c) All issuance amounts reported in or converted to USD on date of issuance. Outstanding amounts adjusted for actual principal losses. 0 9

10 Risk premium Risk premium ILS Market Update Q ILS market statistics Quarterly LTM U.S. Wind exposed weighted average risk premium and expected loss 9.0% 9.0% 6.0% 3.0% 6.3% 6.3% 5.6% 6.1% 5.9% 5.9% 6.2% 6.3% 2.3% 2.3% 2.4% 2.5% 2.5% 2.8% 2.8% 2.0% 7.5% 7.6% 7.3% 6.4% 5.5% 5.4% 6.0% 6.1% 6.1% 6.4% 3.8% 3.9% 3.9% 3.4% 2.8% 2.7% 3.1% 3.0% 3.1% 3.2% 6.0% 3.0% Expected loss 0.0% Q2'14 Q3'14 Q4'14 Q1'15 Q2'15 Q3'15 Q4'15 Q1'16 Q2'16 Q3'16 Q4'16 Q1'17 Q2'17 Q3'17 Q4'17 Q1'18 Q2'18 Q3'18 0.0% Quarterly LTM non-u.s. Wind exposed weighted average risk premium and expected loss 6.0% 6.0% 4.0% 2.0% 3.4% 3.3% 3.5% 3.7% 2.9% 3.1% 3.4% 2.8% 2.7% 2.6% 1.3% 1.3% 1.3% 1.5% 0.8% 0.7% 0.9% 1.0% 1.0% 0.7% 3.7% 3.8% 3.9% 4.5% 4.3% 3.7% 3.5% 3.6% 1.3% 2.4% 2.4% 1.8% 2.0% 1.9% 1.7% 1.4% 4.0% 2.0% Expected loss 0.0% Q2'14 Q3'14 Q4'14 Q1'15 Q2'15 Q3'15 Q4'15 Q1'16 Q2'16 Q3'16 Q4'16 Q1'17 Q2'17 Q3'17 Q4'17 Q1'18 Q2'18 Q3'18 Weighted average risk premium Weighted average expected loss Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018. Aggregate data excludes private ILS deals. LTM = Last 12 months. Aggregate data are for primary issuance and do not reflect secondary trading. 0.0% Secondary market trading overview Investors lamented the Irma creep, and it is interesting to note the traditional cat bond bounce for seasonality was relatively muted. Q saw very light secondary trading. There were intermittent lists of bonds being moved in small size, with very few meaningfully sized trades. Investors lamented the Irma creep, and it is interesting to note that the traditional cat bond bounce for seasonality was relatively muted. We anticipate traders will look optimistically towards the new primary issuances in Q4, which will ultimately help the secondary market settle into appropriate trading ranges. 10

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