Diversification positive, but risk has to be quantifiable: ILS fund managers

As the catastrophe bond market looks to expand outside of the natural catastrophe space, terrorism risk has been highlighted as a potential growth avenue for the insurance-linked securities (ILS) sector, but while new perils bring diversification benefits, it’s essential the risk is quantifiable.

Evidenced by the record-breaking level of catastrophe bond and ILS issuance in the first-quarter of 2018, which followed a record volume of full-year issuance in 2017 and the impacts of last year’s catastrophe events, the ILS market remains buoyant and continues to grow.

To date, and with few exceptions, catastrophe bond issuance has focused on well understood and well modelled catastrophe exposures, mostly in the U.S. but also in Japan, Europe, Australia, and increasingly other parts of the world such as parts of South America.

But while the catastrophe bond market continues to expand its reach in terms of regions, deals that protect exposures outside of the natural catastrophe space are few and far between, and in order for the sector to really expand its footprint, peril expansion is required.

One peril that has been discussed by ILS industry participants as a potential growth area is terrorism, widely regarded as one of the risk transfer sector’s greatest challenges and opportunities.

In light of the potential for ILS to play a meaningful role in the terror risk landscape and also the launch of the PCS Global Terror index, InvestmentEurope recently spoke with a number of ILS fund managers about the possibility of terrorism-linked catastrophe bonds.

“Firstly, the occurrence of events need to be independent from the macro-economic cycle. This is paramount, as we do not want to jeopardize the crucial characteristic of our asset class for investors.

“Secondly, the risk needs to be quantifiable. While we believe terrorism is largely independent from the macro picture, it is difficult to quantify the risk and to extract meaningful trends from historical data,” said Simon Vuille, ILS Portfolio Manager, Lombard Odier Investment Managers.

As noted by Vuille, the very low correlation of ILS to broader financial market and global trends is a vital part of the marketplace, something capital markets investors like about the asset class as well as its diversifying characteristics, so it’s important not to threaten this.

The need to be able to quantify the risk was also something highlighted by Niklaus Hilti, Head ILS Strategies at Credit Suisse Asset Management, who welcomes the expansion of ILS outside of the U.S. nat cat space, but stressed the firm only “invest in risk that we indeed can sufficiently quantify and price.”

“We believe that the currently available catastrophe risk models are able to capture the severity of such events, yet are not sufficiently developed to capture the frequency,” said Hilti.

The ILS investor base is sophisticated and mature, and while it has shown its willingness to participate in new risks and regions, an understanding of the risk is paramount and it appears questions remain around the modelling of a terrorism-linked catastrophe bond.

This was highlighted recently by the Chief Executive Officer (CEO) of Pool Re, the UK’s government-backed mutual terrorism reinsurer, Julian Enoizi, who said that the features and capacity of the ILS space “should be embraced as a logical next step,” but warned that “Models are not yet sufficiently credible to support a bond issue”.

Head of Cat Bonds at Twelve Capital, Florian Steiger, explained to InvestmentEurope that his company has invested in terrorism-linked private ILS solutions, adding that Twelve Capital would welcome a cat bond focused on the peril.

“From a portfolio construction perspective, the inclusion of any diversifying peril is certainly positive and hence, assuming sound underwriting and structuring, cat bonds insuring against property damage from acts of terrorism would most likely be included in our portfolios,” said Steiger.

The terrorism risk transfer space continues to evolve, and while the launch of the PCS Global Terror index and the commitment of the re/insurance and ILS markets to better serve the peril suggests the risk will be better understood in the future, it remains unclear exactly when a terrorism cat bond might come to market, and what it might look like.

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