ILS trigger indemnity shift continues, non-indemnity still important: Willis Re

The shift towards indemnity triggers in the insurance-linked securities (ILS) market has accelerated in 2018, but alternatives such as industry loss index triggers and parametric triggers remain important as well, with the potential to have meaningful impact, according to Willis Re’s ILS team.

In reporting a record third-quarter for ILS and catastrophe bond issuance in 2018, as use of third-party reinsurance capital continues to accelerate, Willis Re notes that all forms of trigger structure have their place and are important, although preference for indemnity has been evident in 2018.

Of course one of the reasons that industry loss index trigger use has declined so far this year is that one of the largest sponsors of these deals, XL Group, has now been acquired by AXA and the resulting AXA XL company has yet to approach the catastrophe bond market since the M&A transaction was consummated.

Willis Re’s new ILS report documents a $1.6 billion quarter of ILS and cat bond issuance, which it puts as a record. This figure sits well below the $2.5 billion of issuance recorded and reported as of October 1st by Artemis in our latest ILS market report as the Willis Re report does not include mortgage ILS activity.

Issuance in Q3 was significantly above the 5-year average of $800 million, the Willis Re report states and the firm puts issuance at $8.7 billion for the year to the end of September, below the $11.88 billion we reported including life ILS, mortgage ILS and private cat bond deals.

Willis Re’s report picks on index triggers this time around, saying that their use if slipping in the market despite the fact they do offer important benefits as well.

In 2018 so far, Willis Re puts indemnity trigger use as 60% of issued catastrophe bonds, which is a significant increase from the 40% a decade earlier.

As we noted, the amount of issuance using an index trigger could have been higher had XL returned to the cat bond market in early 2018 with a similar half a billion or larger deal to its previous years issues.

It’s also important to consider what effect the losses of 2017 may have had, to reinsurance firms that might issue retrocessional cat bonds.

With losses still creeping from the Florida hurricane impacts some of these reinsurers are continuing to evaluate how best to structure their retro programs and our sources suggest that process may mean a number of cat bonds fall into 2019 instead of 2018, which could affect the levels of index trigger usage during this year.

Willis Re thinks it’s largely to do with pricing, saying, “The available premium or risk-spread discount for index triggered instruments has typically declined relative to indemnity triggers, and the share of index-triggered transactions has fallen in step.

“This good-news story reflects improved data, transparency, and understanding of indemnity risk, rather than any inherent discomfort with index triggers.”

This is indeed a good news story, however it’s not clear that 2018 issuance so far reflects any significant further shift away from index triggers to indemnity, by any sponsors who actually came to market.

In fact all of the reinsurance firms who issued catastrophe bonds for retrocessional purposes in 2018 so far have used an industry loss index trigger, while the users of indemnity triggers are those looking for reinsurance cover.

Looking at Artemis Catastrophe Bond Deal Directory data, it seems the main reason for a decline in index trigger usage in 2018 is largely the absence of XL as a sponsor so far this year and the fact no other reinsurers came to the market for retrocession.

That’s not to say there hasn’t been a gradual shift towards indemnity triggers, as this has been evidenced and commented on year after year and we track the use of triggers in the ILS market here.

It’s clear the use of indemnity triggers has increased, for the better for the market’s sponsors.

But as well as primary insurer sponsors clear preference for indemnity coverage, we’d also attribute that to other factors including the general expansion of ILS which has resulted in more primary sponsors coming to market and external factors such as the increased availability of other collateralized retrocession options in the last decade, both of which have helped to influence the trigger shift in ILS markets.

“Index triggers remain important,” Willis Re says. “Based on a proxy for actual loss, they remain common for retrocession cat bonds and ILWs. In addition, when underlying data quality is poor or the coverage is exceptionally difficult to model, index-trigger discounts often rise considerably, making the structures more attractive, as seen with recent sovereign natural catastrophe and extreme mortality ILS deals.”

Bill Dubinsky, Managing Director & Head of ILS at Willis Re, commented, “As the insurance, reinsurance, and ILS markets work together to solve new problems for insureds, index triggers are a very useful tool to consider. They may not, on their own, close the global protection gap, dramatically grow the ILS market, or solve all cedant problems, but with creativity, unbiased advice, and sustained effort, they can still have a meaningful impact.”

It’s also important to remember that the reason some cedants prefer indemnity coverage is to prevent so-called basis risk, or any gaps between the claim/payout they felt they should have had and the claim/payout the trigger actually provides.

But with the way reinsurance and retrocession is purchased being ripe for disruption, perhaps as a next phase of the evolution of the market, a reimagination of the reinsurance tower may eventually lead to greater use of index related triggers, be they parametric or industry loss based, once the market finds more effective ways to model their exposures and how they actually need their protection to respond to them.

As a result, technology and access to platforms that make reinsurance capital allocation more efficient, may actually stimulate cedants to look again at the way different types of triggers can be integrated into their risk management programs, which could result in a resurgence or more widespread use, as response of coverage becomes as important as it being matched with indemnity.

As Willis Re says, non-indemnity and index triggers remain very important in the ILS sector, but there is a chance they become more important for everyone in future, as technology helps to minimise the impacts from, and even perception of, basis risk.