Verisk Analytics / ISO revisits feasibility of exchange-trading of risk

Verisk Analytics division ISO is investigating the feasibility of exchange-traded risk again, as it looks to work with the insurance and reinsurance industry to identify why past efforts have failed to take-off and how a workable solution could be launched in the future.

ISO is a leading provider of information and data on property & casualty insurance risk and a sister business to Property Claim Services (PCS). As such it has been involved in a number of initiatives looking at creating catastrophe risk exchanges and exchange-traded insurance risk opportunities in the past.

Today, though, ISO feels that the market may be more ready than ever before to work together to develop a solution, that finds a way to overcome the hurdles of finding sufficient original risk to make an exchange-traded product work viable and creating something that the industry really needs and can also attract hedgers, market makers and other potential traders to a risk exchange platform.

“As a market we intuitively see this as something we want,” Tom Johansmeyer, assistant vice president – Reinsurance Services at ISO, commented during a webinar he facilitated today on this topic.

Johansmeyer is leading the ISO’s exploration of the potential appetite for an exchange-traded risk solution, however the organisation is taking a broad view of the potential risks that could be traded, so looking outside just catastrophe risks alone and also taking a broader view of potential triggers, so looking beyond the industry loss triggers that its PCS business provides.

“We see this as an opportunity to facilitate an insurance, reinsurance and insurance-linked securities (ILS) market discussion on exchange-traded risks,” Johansmeyer explained to Artemis.

“There is a growing appetite to see progress being made towards a solution, but past efforts have failed to gain the traction that perhaps is required to make an exchange-traded product sustainable,” he continued.

The continued growth, development and maturation of the ILS market and catastrophe bonds, as well as reinsurance instruments such as the industry loss warranty (ILW), has driven increasing interest among market participants in seeing an exchange-traded solution emerge.

As technology advances, risk modelling improves and becomes more granular, the range of triggers broadens and also the understanding of catastrophe risk as an asset class gains traction, it is thought that the time might be right to revisit the initiative.

Johansmeyer sees the topic of original risk as a key issue that has held back the development of exchange-trading in catastrophe risk in the past, but highlights opportunities to create new risk premiums, by narrowing the protection gap, looking to microinsurance type products and also looking more broadly at other classes of insurance which have catastrophic layers of risk embedded in them (think energy, marine etc).

There is also the subject of synthetic instruments, such as those linked to a parametric or industry index but which do not cover specific insurable premiums, which needs to be considered. This would be a product more akin to the financial hedging or exchange traded funds or notes that the broader financial markets have embraced. Why shouldn’t insurance and reinsurance have the same?

Any solution needs to have structural simplicity, needs to be quick to bring to market, have reduced frictional costs compared to other forms of risk transfer and be able to attract both sides of the deal, so hedger and capital provider or risk market.

If a solution or product can be found, that either wraps up insurable premium into a tradable risk object, or creates a synthetic tradable hedging instrument that the market will use, there is the potential for it to be rapidly adopted.

Johansmeyer said that there would be the potential to access new forms of risks, new structures and new risk counter parties or capital providers, through such products and exchanges. However, he reiterated that the market either needs more access to the original risk, more new premium that can be traded electronically or over an exchange, or to accept a synthetic hedging product based on an index-trigger (be that parametric, industry loss based, or other).

Johansmeyer explained; “We know that exchange-traded risk has been tried before. We even put a team together two years ago to explore this, and we ultimately bumped up against an original risk problem that led us to reevaluate the effort. This time around – as with last time – we’re responding both to direct market inquiries and the notion that exchange-traded risk is an intuitive next step to cat bond lite in terms of innovation at the efficiency end of the ILS spectrum.

“Of course, we don’t see this as a problem for one company to solve. An effective market – exchange-traded or otherwise – requires broad support and participation from a variety of stakeholders. As we explore the opportunities around an exchange-traded risk environment, we welcome the opportunity to engage with the industry as a whole to work together toward the appropriate end.”

The fact that we do not have a well-used, exchange-traded, catastrophe risk linked instrument in the market right now remains a mystery to many. It makes a huge amount of sense to many protection buyers, markets, third-party investors, ILS fund managers and financial market traders.

The work, effort and investment that ISO is putting into this exploration of the potential for exchange-trading could be extremely valuable to the whole market. We’d urge you to get involved.