The logical place for peak natural catastrophe risks lies in the global capital markets, not the traditional reinsurance market, according to Samir Shah, Chief Reinsurance Officer of insurer AIG.
The 144A catastrophe bond market was originally devised as a way to take the peak natural peril risks, the ones which insurers and reinsurers did not want to hold on their books or transfer internally within the reinsurance market, and transfer them out to the largest source of available capital, the global capital markets and its institutional investors.
Samir Shah, Senior Vice President and Chief Reinsurance Officer of AIG Property Casualty, a sponsor of catastrophe bond transactions such as the Tradewynd Re and Lodestone Re programs (read all about them in the Artemis Deal Directory), was speaking during a panel session on the role of the 144A catastrophe bond structure at yesterday’s SIFMA IRLS 2014 conference in New York.
His comments show that the original reason that the cat bond was devised as a risk transfer tool has not changed. For peak catastrophe risks the source of capital large enough and best able to absorb it is the capital market and its institutional investors and Shah discussed some of the reasons for that as well as how AIG thinks about the catastrophe bond market.
Shah commented; ” I personally believe that the logical place to put cat risk is in the capital markets to get the maximum diversification benefit.”
Here Samir Shah is referring to the diversification of AIG’s sources of reinsurance capital. By leveraging capital market investors as an additional source of reinsurance capital AIG is diversifying away from sole reliance on traditional reinsurance companies. AIG also benefits from the lower cost of institutional money as well as the efficiency, transparency and liquidity of buying into a capital market securitised product.
Shah believes that use of the capital markets as a source of reinsurance and retrocessional reinsurance capacity for peak natural catastrophe risks will ultimately help to grow the volume of insurance premium in the market. Shah is referring to the lower cost of capital and efficiency inherent in capital markets reinsurance transaction and how that could help insurers like AIG to grow their book.
He explained; “I think that in doing that we lower the cost of risk and when we lower the cost of risk insurance volume goes up. I think we would all agree that there is still a meaningful difference between economic losses after a cat event versus insured losses. When we lower the cost of risk there is more insurance, we narrow that gap, communities benefit, regions benefit and society benefits. As one of the largest cat underwriters it changes the value proposition we offer our clients. We can help our clients reduce their cost of risk.”
Shah then discussed the cat bond as a structure and why it is well-suited to help insurers like AIG achieve these goals; “We think the cat bond is the logical structure, the best structure, to deliver that vision. I can envision a very robust asset class with proper benchmarks, a very large secondary market that offers liquidity and price discovery.”
Referring again to the lower cost of capital markets money as a source of reinsurance, Shah said it could flatten the insurance pricing cycle; “It would also decouple the pricing of cat risk with the occurrence of cat events. As we all know whenever there is a cat event pricing goes up. Thinking again from an insured perspective, the first thing they want after a cat event is to get paid, the second thing they want is to continue to get that insurance at a reasonable price.”
As the insurance-linked securities (ILS) market grows and the volume of capital markets money increases in the reinsurance space we are beginning to see evidence of this trend, with pricing and rates coming down across many areas of the market. How the insurance and reinsurance rate environment will react after the next major catastrophe event is becoming less certain, with many believing that the decoupling of pricing from the occurrence of catastrophe events is now a real possibility.
Shah continued; “Currently what typically happens is the pricing doubles or triples and pulls away from the market. Putting this into the capital markets should, in theory at least, decouple that. So we see a lot of benefits to placing this in the capital markets through cat bonds.”
But for AIG the catastrophe bond market is still not an essential part of its reinsurance program, the insurer could probably purchase traditional reinsurance just as cheaply in the current market rate environment especially given the size of its reinsurance program. However Shah and AIG are committed to the catastrophe bond market and clearly see the capital market as the ultimate home for much of the peak natural catastrophe risk from insurance markets.
Shah said; “So now when we enter the capital markets, we’re doing it as a way to take meaningful steps towards that vision and working with investors and other experts to do our part. We really don’t need to enter the market we do it with a longer term objective.”
It’s interesting to see that the same thoughts, ideas and vision which led to the creation of catastrophe bonds as a tool to transfer insurance risk to the capital markets still exist today. The efficiency, large pool of lower cost capital, transparency, transferability and liquidity aspects all hold true today and insurers like AIG clearly see the catastrophe bond as a structure that will grow in usage and become one of the leading tools for peak natural catastrophe risk transfer in years to come.
During the SIFMA IRLS event there were many references to the catastrophe bond and ILS markets age, at around 17 years old, with some joking that the market has just reached drinking age (Artemis falls just shy of drinking age at 15 years old this May). Samir Shah’s comments suggest the market has a way to go before reaching maturity. Investor demand would seem to agree as the number of investors interested in ILS and cat bonds as an asset class increases steadily.
How big the catastrophe bond market will be at 21, perhaps the next milestone in terms of reaching adulthood, is anyone’s guess. But with insurers like AIG committed, and the strong turnout at the SIFMA IRLS event demonstrating the increasing interest in the space, its hard to visualise the cat bond market in 4 years time as anything but a great deal larger, more mature and more important than it is today.