Swiss Re Insurance-Linked Fund Management

Original Risk: A Society for Change Agents

In time, exotic ILS might not be so exotic after all: John Seo, Fermat Capital


The utilisation of insurance-linked securities (ILS) structures and capacity for exotic, or man-made risks remains small, but as the world continues to evolve and new risks increasingly emerge, these types of exposures might turn out to be not so exotic after all, according to John Seo, Co-founder and Managing Director of Fermat Capital.

John Seo, Fermat Capital ManagementMost commonly known and utilised to protect against low frequency, high severity natural catastrophe exposures, such as hurricanes and earthquakes, the ILS market – driven by catastrophe bonds and collateralised reinsurance – continues to push boundaries and reach new heights.

Supporting the industry’s expansion into new weather-related perils and additional regions, is a smaller and lesser known sub-sector of the ILS universe that is exposed to exotic, or man-made risks, which includes exposures such as terrorism, cyber, or pandemics.

In a recent communication to his investors, Seo states that while some investors are understandably uncomfortable with investing in the more exotic ILS, the inclusion of such an exposure within an ILS portfolio can “create attractive intra-portfolio diversification opportunities for ILS funds.”

According to Seo, a good ILS investment has three general features; that ILS should relate to important risks; that the ILS should have risks that are reasonably quantifiable (modellability); and, that loss to the ILS should not be triggered by a market crash (non-correlation).

Seo clarifies that his one-way non-correlation criterion does not exclude ILS risks that might move markets, pointing out that a large enough earthquake has the potential to affect stock markets.

“None of the above provides an obvious bar to engaging in ILS focused on man-made risks. It is important to note that man-made risk is a natural part of insurance markets in the sense that insurance claims themselves are subject to significant behavioural elements,” explains Seo.

In the catastrophe bond market, which as shown by the Artemis Deal Directory is the second largest sub-sector of the space with an outstanding market size of almost $40 billion, both pandemic and terror risks have now featured.

In 2017, a $320 million IBRD CAR 111-112 issuance came to market, sponsored by the World Bank’s Pandemic Emergency Facility (PEF) and which provides parametric insurance protection linked to the occurrence of specific pandemics.

More recently, UK government-backed mutual terrorism reinsurance facility, Pool Re, sponsored a £75 million catastrophe bond issuance called Baltic PCC Limited, which provides Pool Re with retrocessional reinsurance protection against terrorism risks in the UK.

Discussing the terrorism catastrophe bond, Seo explains how two key ILS investment elements came together.

“First, it was brought to market to ostensibly address an issue of national importance. Second, the risk disclosures were sufficient to enable the replication of the risk modelling of the bond by investors to allow them to perform their own sensitivity and model stress tests.”

While small and emerging, exotic ILS transactions have been well received by the investor community, underpinned by the fact that the first terrorism cat bond was oversubscribed, and which suggests that future deals will likely be supported by the ILS investor base.

As highlighted by Seo, in some instances, exotic risks can add diversification within an ILS portfolio while at the same time meet the key ILS investment principles.

However, and despite clear investor support for such transactions so far, Seo believes that in general, exotic perils will remain a minor part of the broader ILS market in the near-term, at least in terms of notional risk exposure outstanding.

“Again, this comes back to the observation that natural catastrophe risk is so much bigger than exotic ILS risks,” says Seo.

Adding: “However as people and productivity continue to progress, both physically and virtually, new risks will increasingly emerge – perhaps even some with the potential to create insured losses that equal or exceed the current risks to property from natural perils.

“In the long run therefore, in the decade and more ahead, as demand for risk capacity begins to exceed the available reinsurance supply, what we currently call ILS exotic risks may not be so exotic after all. All the more reason, we believe, for us to pay attention to these investment opportunities as they emerge today.”

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