Volatility drives need for contingent sources of capital: Liès

by Artemis on October 23, 2012

One of the key events in the reinsurance cycle is currently underway in Germany. The Baden-Baden Reinsurance Symposium is another event which presents an opportunity for reinsurers, brokers and cedants to meet and discuss pricing, rates and availability of coverage for the forthcoming January renewals. One of the issues raised which is worthy of some further discussion was Michel Liès, Group CEO of Swiss Re, comments on volatility.

Michel Liès was delivering a keynote speech at an event hosted by Guy Carpenter on Sunday 21st October which aimed to explore the topic “Volatility – Opportunity or Threat?”. The event looked at how the insurance and reinsurance industry view volatility and turbulent times within the market, particularly from a financial perspective.

In the keynote Michel Liès discussed the critical role that reinsurers play in supporting clients, and the market as a whole, in difficult times. He said that volatility is a factor that is not going away and that reinsurers have a role to play in smoothing clients journey through challenging times while acting as a shock absorber within society. He said; “With the gap between insured losses and economic losses continuing to grow, last year’s largest ever catastrophe-related economic losses serve as a reminder that there is significant potential for our industry and the solutions we provide.”

Liès said that volatility is something we have to live with and that it is not decreasing, rather it is increasing. He cited stock market volatility, volatility on the liability side of reinsurers and insurers balance sheets and also an increasingly volatile environment and climate to come to terms with.

On the topic of natural catastrophes, Liès said that these create volatility for the re/insurer on both sides of the balance sheet. He said that liquidity impacts when attempting to raise capital can be an issue and raising capital becomes a more expensive operation for re/insurers. This is something that has been noted since 2011 when some have had a much easier time raising capital than others, and the capital has tended to flow towards where the return can be greater. Liès said that he feels that the increasing volatility should be driving reinsurance rates upwards, citing issues such as the low-interest rate environment, catastrophe losses and increasing regulation as factors that would require rates to continue to rise, although perhaps not rapidly for the moment.

Liès said that this makes contingent sources of capital all the more important. Now, we don’t know whether Liès is referring explicitly to the contingent capital facilities which have been used by a number of reinsurers in the past, but it seems a good time to raise them as an idea.

In volatile times a contingent source of capital is a very good solution for a reinsurer. Both in the traditional sense of a contingent capital facility which is triggered based on specified factors which could be anything from a decline in share value to a large catastrophe loss. There has been some innovation in the contingent capital world but the facilities have not been as widely used as was perhaps thought a couple of years ago.

Catastrophe bonds can also provide a contingent source of capital designed to payout when volatility strikes a business. A great example of this would be the MyLotto24 cat bond structure which provided the company with a source of contingent risk transfer for lottery winnings on their games reaching above a predefined point. The idea that contingent capital could be securitised and sold to investors in this way makes a lot of sense.

Perhaps it’s time for some innovation in the contingent capital world? SCOR, the French reinsurer, have an innovative contingent capital facility which is structured in such a way that it acts as a line of equity but can be triggered by catastrophe indemnity losses they suffer or by a decline in share price.

Contingent capital facilities can be much cheaper to put into place than a cat bond and can in fact be much more customised if required, as the counterparty is the only backer who needs to be comfortable with the transaction, unlike a cat bond where a group of investors is involved.

Perhaps insurers and reinsurers should be looking at ways they can customise contingent capital facilities to provide similar cover to reinsurance, retrocession and cat bonds. Maybe parametric triggers could be included alongside an indemnity trigger to provide contingent capital when peak disasters hit the most exposed regions of the world, or perhaps they can address the frequency issue by being structured on an annual aggregate basis. It seems to us that the contingent capital facility is a tool which has a lot of promise and is currently being underutilised.

Michel Liès noted that the increasing volatility in the world, and affecting the reinsurance market, drives the need for transparency with clients and investors alike. He specifically noted that catastrophe bonds have been driving forward transparency between reinsurers and investors and said that it was a positive development.

In volatile times the reinsurance and insurance sectors need to find ways to innovate, embrace the new risk transfer tools which are available and educate the capital markets on their uses so as to encourage them to make capital available to support risk transfer and contingent facilities.

Here are some other articles from our archive on contingent capital facilities (most recent first):

- SCOR extends natural catastrophe contingent capital facility

- Farmers Exchanges renews $500m contingent capital surplus note facility

- Swiss Re looks to increase use of contingent capital

- Moody’s positive on contingent capital facilities, expects more

- Allianz sets up €500m contingent capital facility with Nippon Life

- Catastrophe losses trigger contingent capital facility for SCOR

- SCOR finalizes natural catastrophe contingent capital solution

- Société Générale launches EDGE; a contingent capital solution for insurers and reinsurers

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