Experts in insurance-linked securities (ILS), catastrophe bonds and traditional reinsurance are increasingly vocal about the ability of these private markets to take on a larger slice of global terrorism risk, reducing the need for governments to finance so much of this risk.
For example under the Terrorism Risk Insurance Act (TRIA) the U.S. government has to pick up the bill for the bulk of any terrorism insurance loss above $100m in size. This enables insurers to provide terrorism cover safe in the knowledge that the government will foot the majority of the bill if the worst occurred. This also means insurers don’t need to buy as much private reinsurance coverage for terror risks.
The stability of TRIA seems constantly under threat as each renewal of the agreements behind the Act sees more doubt thrown on whether the government should be providing this backstop. Some people in the private reinsurance and ILS market believe that TRIA should pass some of that burden onto reinsurers and the capital markets.
Increasingly reinsurance industry executives have been citing terror risk as an area of opportunity for the sector, where they feel risks can be priced adequately to allow the private reinsurance market to take a larger slice. With global reinsurance capital at a high, both traditional and non-traditional, reinsurers feel that the market is ready to assume more of this risk.
Validus Group have been particularly vocal about the reinsurance markets ability to take on terrorism risk. Validus CEO Ed Noonan recently commented that there is no reason that terror risks should be pushed to the government through TRIA and that the reinsurance industry should be pushing to obtain more of this business.
Kean Driscoll, CEO of Validus Reinsurance Ltd. recently said that reinsurance and ILS, or alternative reinsurance capital, is ready to take on terror risks; “The industry hasn’t served itself well before Congress, saying that traditional terrorism cannot be priced. We disagree with that. As an industry, we committed substantial resources on how to price the frequency of traditional terrorism. We’re of the view that the market could bear more traditional terrorism risk.”
RenaissanceRe is another reinsurer which feels ready to participate more meaningfully in underwriting of terrorism risks. Kevin O’Donnell, CEO and President of RenRe, said recently that his firm has the ability to write terror risk, and has done over the years, so if demand for terrorism risk reinsurance increases he feels the capacity will be available to support it.
The fact that reinsurers are ready to take on more terror risk has been widely publicised over the last few years, as discussions over the extension of TRIA have become increasingly protracted. Now the ILS and alternative reinsurance capital space is becoming more vocal as well and some firms are actively targeting terror as a new line of business already.
A number of third-party reinsurance capital backed facilities, funds or sidecars are planning to underwrite terror risks, which over time means that investors in insurance-linked securities and collateralized reinsurance will gradually gain a larger amount of terror risk within their portfolios.
An example of a newly formed alternative vehicle which will write some terror risk is Lancashire Holdings new Kinesis product. Kinesis will offer multi-class reinsurance and retrocession solutions on a fully-collateralized, and third-party capital backed, basis. Kinesis will target short to medium tail lines of business, including terrorism.
Lancashire’s offering will be highly customised product, so in no way does this and other efforts see terrorism risk becoming a commoditized part of the ILS and alternative reinsurance market. However some do see an opportunity for terrorism to be covered more frequently and on a larger scale by ILS and the capital markets, as perhaps the only source of capital large enough to meaningfully take on terror risk should TRIA fail to be renewed.
Validus believes the ILS market is ready to take on terror risk. Noonan commented recently; “Frankly, perhaps not on day one, it won’t take too long before you can start packaging it up into the ILS market. We know investors in the ILS market today who would like to take on that risk. And so it won’t take very long, I think, for ILS to start to provide the high-layer type of capital required.”
Another proponent of the ability of third-party capital to take on terrorism risk through insurance-linked securities (ILS) and catastrophe bonds is specialist ILS investment manager Fermat Capital’s co-founder and managing principal John Seo. Seo recently appeared at the U.S. House of Representatives where he presented the idea that the ILS and cat bond market could take on terrorism risk to a Subcommittee on Housing and Insurance.
Seo noted in his testimony that in ILS and catastrophe bonds, it is often the case that a risk that was once felt too unusual for the cat bond market can suddenly become commonplace afer just a few years. He cited the example of the New York MTA and its storm surge flooding cat bond, saying that now that this type of deal had been transacted once the cat bond market is likely to see more.
Seo explained that the ILS market has already provided coverage for terrorism risks, beginning with the successful issuance of Golden Goal Finance Ltd. in October 2003, which provided cover for cancellation risks, including due to terrorism, for the 2006 FIFA World Cup.
That is the only example of a cat bond which covered terrorism risks so explicitly, but Seo explained that there a number of cat bond structures which cover mortality risks including from terrorism events. This means that the cat bond market is actually covering around $1.4 billion of terrorism risk at the moment anyway, Seo said, adding that if you extrapolated that to include the non-cat bond side of ILS it may be as much as $3 billion.
Interestingly, Seo pointed out that when Golden Goal Finance came to market it was approximately 7% of the outstanding cat bond market. Today, at $1.4 billion terrorism risks remain approximately 7% of the outstanding cat bond market. At $3 billion, terrorism would account for just under 7% of the convergence reinsurance market, so collateralized reinsurance and ILS.
If the ILS space sees the growth which has been forecast, of $150 billion to $200 billion of capacity by the end of the decade, Seo said that terrorism risks could see as much as $9 billion to $12 billion of available third-party reinsurance and ILS capacity available. If the ILS market could more widely accept terrorism risk then Seo said that number could be higher, nearer to $20 billion to $30 billion.
Seo said that the figures show that the ILS market does have an appetite for terrorism risk under the right circumstances. He said; “They certainly do not support the conclusion that ILS markets have exhibited no appetite for terrorism risk to date. Given the proper information, it seems clear that ILS markets to date have kept an open mind on terrorism risk — nothing more and nothing less”
Seo discussed the ILS investor base, explaining the difference between fast and slow money in the market and that the pension fund investors who increasingly make up the bulk of the ILS market are willing to take on risks where there can be some correlation (between different types of risks) as long as they are being adequately compensated for it.
This is an important factor to consider when thinking about the potential for the ILS and cat bond market to expand. These investors are willing to consider more complex transactions and unusual risks, like terrorism, as long as the pricing is adequate and the transactions show diligence in terms of modelling and structures.
Seo made two suggestions for ways to get the ILS market to take on more terrorism risk. Firstly by bundling some terror risk within other catastrophe bond transactions, perhaps meaning that by putting property losses from terrorism alongside property losses from catastrophes some efficiencies could be gained.
Secondly Seo said that the ILS market believes that nuclear, biological, chemical and radiological (NBCR) terror risks are much less well understood than more conventional terror risks. He suggested that ILS to cover terrorism should perhaps exclude these risks, thus improving the efficiency of coverage for the other risks with ILS.
That last suggestion is interesting, as these risks have the potential to be so large and damaging that perhaps this is where government backstops such as TRIA should focus. The ILS market certainly seeks to avoid the ‘unknowable’ in the risks it takes on. The unmodelled is one thing, but a risk which has the potential to be so hugely catastrophic as NBCR is perhaps best removed from transactions through exclusion.
Cyber terrorism is another risk which is fast emerging but which is largely unmodelled and extremely difficult to predict. It too has the potential to create enormous losses, particularly in terms of business interruption, so perhaps should also be excluded from the ILS markets remit in terrorism risks.
John Seo’s testimony to the subcommittee will have helped to raise the profile of the ILS space once again in front of lawmakers, hopefully demonstrating that the ILS market is capable of providing some level of backstop for risks like terrorism. Until TRIA either fails to renew, or is restructured with the specific goal of passing more terrorism risk to the private reinsurance market, we are unlikely to see a flurry of terrorism ILS deals anytime soon.
The main thing to note is that the appetite to take on terrorism risk is clearly apparent both among traditional reinsurance firms and the alternative reinsurance capital providers and ILS market. At some point in the future we will likely see more of this risk coming into the private sector, potentially becoming a target for transformation into a form to suit capital markets investors.
You can read John Seo’s testimony in full here.
Read some of our older articles on the potential for terrorism risk ILS and catastrophe bonds: