Are investors compensated for uncertainty in indemnity cat bonds?

An interesting question was raised at the recent 2014 Bermuda in Boston conference held by investment bank Macquarie, whether ILS investors are being compensated sufficiently for uncertainty in some indemnity catastrophe bonds and ILS transactions.

Insurance-linked securities (ILS) investors typically hope to be compensated for any level of uncertainty or for the inclusion of unmodelled risks, at least to a degree, with conversations during the marketing of a cat bond or other ILS deal expected to allow for discussion as to where the pricing should close.

Panelists at the Macquarie event questioned whether this is happening on some indemnity transactions now, saying that they did not feel that the current spread between yields on parametric and indemnity bonds was wide enough, meaning that investors are perhaps not being compensated sufficiently for certain indemnity cat bonds.

When investing in an indemnity cat bond the ILS investors are taking on an element of risk from the cedent, with exposure to the sponsor or cedents internal processes as well as to any uncertainty due to the modelling or any unmodelled risks which are included.

At a Standard & Poor’s event held in London yesterday, Maren Josefs, Associate Director of Insurance Ratings at S&P, said that from the rating agency point of view, S&P would caution investors that did not have deep enough modelling and actuarial experience and skills.

Effectively, when investing in indemnity transactions, which are the fastest growing trigger segment of the catastrophe bond market, investors are exposing themselves to, and taking on, an element of the sponsors underwriting and claims process risk.

During the same panel, Jonathan Barnes, Senior Advisor at ILS specialists Securis Investment Partners LLP, said that investors should constantly question indemnity transactions and that assessing both the modelled and unmodelled risks that could be included was important.

Barnes also explained that as the ILS fund manager space has grown and the sector has moved towards the indemnity trigger model in order to more closely match traditional covers, it has become increasingly important to have risk modellers and actuaries in the teams, which is resulting in much larger operations.

When it comes to investing in private indemnity ILS transactions, some investors should not even attempt it, said Barnes suggesting that some of the smaller players may not be able to properly assess the more complex indemnity triggered ILS deals.

The panelists at the Macquarie event believed that the difference between the returns on a parametric trigger and the returns on certain indemnity transactions are not sufficient, given the parametric triggers payout is predictable but the indemnity structure has the potential to contain a great deal of uncertainty.

The panelists agreed that indemnity triggers contain many more “unknown unknowns”, making it much more difficult to model the risks, ensure all risks are modelled, assess those which fall outside of the models and also to quantify the credit risk of the transaction.

This doesn’t necessarily suggest that indemnity bonds are poorly priced. Granted they are priced very cheaply right now but that is a function of the market environment and high levels of capital. Rather it means that certain deals, particularly those with unmodelled risks, may not be compensating investors as well as the panelists would have expected.

The lesson here, perhaps, is that indemnity transactions need to be approached carefully and that investors and ILS fund managers should ensure that they are comfortable that the level of disclosure is sufficient, that the claims process is well documented and that any risks that are unmodelled, or fall outside of the model used, have been fully assessed and understood by their own teams of specialists.

If they are unable to do this and aren’t comfortable, the best course of action is to turn away and find another deal.

The question of whether investors are compensated sufficiently for assuming unmodelled risks and uncertainty in indemnity transactions still stands and we likely won’t know the answer until we see an unmodelled loss, or something that was unexpected, cause a catastrophe bond to be triggered. At that point investors will decide for themselves whether they have been compensated and, if they feel not, will demand more for their money in future.

ILS managers and the more sophisticated investors with the ability to model these indemnity risks will make their own minds up whether they are compensated sufficiently and likely do not invest in anything they believe does not meet their risk appetite anyway. However there are likely some investors taking on uncertainty who perhaps shouldn’t, a trait of any financial market.

With ILS investment managers increasingly ramping up and hiring specialists to help them assess indemnity transactions we can expect to see the prevalence of the indemnity trigger continue to dominate. Those investors without the resource to get comfortable with these deals should, perhaps, look to how they can offer innovative products on an index or parametric trigger basis, in order to keep the deals flowing.