Interview: Dr. Erwann O. Michel-Kerjan of The Wharton School on ILS risk spreads

This interview with Dr. Erwann O. Michel-Kerjan of The Wharton School discusses the impact of risk spreads on insurance-linked securities (ILS) and how the changes in spreads affect the insurance and reinsurance inked securities markets growth.

This interview is taken from the recently published report by specialist financial services, pensions and investments publisher Clear Path Analysis, titled ‘Insurance-Linked Securities for Institutional Investors 2014.’ Artemis owner and editor Steve Evans was the interviewer and Clear Path Analysis have kindly allowed us to republish it here in full.

Interview participant:

– Dr. Erwann O. Michel-Kerjan, Managing Director, Risk Management and Decision Processes Center, The Wharton School, University of Pennslyvania.

Steve Evans: What key changes have there been to ILS risk spreads over the last year?

Dr. Erwann O. Michel-Kerjan: Over the last 18 months there has been a gradual slide in rates which has helped make these products more affordable for those who are issuing the bonds. However, on the demand side this has resulted in lower returns, of course.

There are three drivers that explain this recent trend, with the first being the overall current capital market conditions. 2013 was free from any significant catastrophes which subsequently resulted in a large amount of available capital in the reinsurance market. Typically, if the rate-on-line of a reinsurance product drops, so does the rate of the catastrophe (CAT) bonds (reflecting cheaper capital available). We’re now seeing ILS premiums below 500 points above the collateral threshold. Although this is much lower than the 8% or 9% seen a few years back, I would argue it is a natural variability of the market.

The second driver is around the subtleties between different types of CAT bonds and the types of products actually being sold. One often hears about the ILS market as if it were homogeneous; it’s not. The price of two different cat bonds, for instance, will be higher or lower depending on what the expected loss is for these two products. Many of the new issuances we have seen trigger with a higher return period (i.e., lower likelihood and lower expected loss); in effect, that means investors are actually being compensated for taking on less risk.

All of that can quickly change, though. If a big disaster occurs in 2014, spreads are likely to start increasing again.

This leads me to the third driver: how the financial markets are doing. 2013 was a remarkable year in the U.S. with the S&P 500 gaining 20%. That said, now all eyes are on the market with some anticipating that we could be on the verge of another financial crisis, or at least a severe correction. Add to that Europe’s rocky situation and the lower than expected growth in several emerging markets, and the picture is a little bit more scary. All of these factors have the potential to impact the cost of capital in the short and long-term.

Steve: There is momentum behind market growth but how can this be ramped up further over the next 5 years?

Erwann: This can be approached from two ways: knowledge and simplicity, both of which will lead to a larger and more liquid market.

Firstly, we should celebrate that the CAT bond market is currently above $20 billion of outstanding capital, far more than in the past, and so clearly the ILS market is moving in the right direction. Can we double it in the next 5 years? The answer is certainly yes.

Experience shows that we need to provide greater education around the specific products targeted to a large spectrum of investors who, in the main, are not used to dealing with probabilistic risk assessment on natural disasters, terrorism or pandemics.

In order to convince pension funds that ILS is a good addition for a small part of their portfolio, they need to understand what they’re buying as it’s not just finance but science, climatology, engineering and medicine. These are two different worlds whereby engineers and pension fund managers won’t be talking to each other, but it is imperative that they do and start to understand the catastrophe risk modelling behind the pricing of these bonds. This has already started to happen.

Education is a big part of the equation, particularly if you consider that the return of these bonds must fit into a pension fund’s long-term time horizon. An interesting parallel is the recent issuance of green bonds for instance (by Zurich Insurance Group). Several very large asset managers are also looking at this market. The more alternative bonds that we see added to municipality bonds, the more mainstream these CAT bonds will become.

Second – simplicity. We have to make these instruments simpler; almost by definition this is how you will make both investors and issuers cross the decision line.

Also, only a few of the 250+ CAT bonds issued have triggered. I’m not saying more need to be triggered, but because only a handful of them have, some people question whether they might be paying the premium for nothing, because the attachment point is too high. You can imagine many more bonds being issued with tranches that would trigger at a lower level. Parametric bonds of that nature should appeal to a large number of issuers which one could pool together, rather than having only one issuer at a time, which results in high administrative costs and fees. By pooling issuers you reach economies of scale. Think of a Category 3 hurricane hitting Miami-Dade next year. I could think of a number of public and private organisations that would benefit from post-disaster funding. If you pool issuances and pool buy-ins (through a CAT bond index), we would certainly make a significant progress is making this market more liquid.

Steve: What do you think we need to do to get these products into emerging economies?

Erwann: It goes back to education. Many of these discussions on the disaster management side are typically handled by the Ministry of the Environment (natural disasters) or the Ministry of Health (pandemics).

In most countries neither has the financial expertise to understand ILS. On the other hand, whilst the Ministry of Finance does, they are too removed from the handling of catastrophes, until after a disaster when relief is needed. Experience shows that when you bring those decision makers together, then actions can be taken.

Steve: What new measures are governments, rating agencies and other key market players considering?

Erwann: Historically, ILS has been regarded as a private sector product. That said, over the past few years there has been bond issuance by state insurance programmes such as the California Earthquake Authority and the Florida Hurricane Catastrophe Fund.

Governments around the world have now started to put the question of disaster risk financing on their agenda at a more strategic level. For instance, I participated in the 2012 G20 Summit in Mexico where the Mexican Presidency assembled a dedicated group to help finance ministers and senior policy makers think more strategically about disaster financing. This was the first time that G20 members considered that topic to be a priority.

I’ve been privileged to have spoken several times at the World Economic Forum in Davos and can equally say the topic is becoming increasingly important on their agenda.

Certainly insurance (and ILS) is not the only solution but it should definitely be part of the solution. Another interesting trend I’m observing comes from the rating agencies, which are obviously a key player. They are now increasingly including a corporation’s risk management plan into their assessment – and not just financial risk management, but operational, too. Although they aren’t downgrading a corporation for not doing X, Y and Z, they are emphasising the importance of proper risk management.

If this rating trend observed in the business community moves to the public sector, that will be a key change. One could easily think of the necessity to rate a sovereign bond or a municipality bond with some consideration being given to how exposed this country or city is to disasters. After all, disasters have proved to be a key driver of loan default for small businesses around the world. If central governments are faced with increasing demand for providing free relief disaster after a disaster, pressure will increase for finding alternative risk financing solutions to be put in place before a catastrophe, rather than relying on taxpayers’ money. This is happening here in the United States and in the UK too as we speak.

Steve: Catastrophic risks have enormous financial impact for businesses and countries. What is happening?

Erwann: That’s a big question. Over the past decade there has been increased occurrence of more devastating catastrophes. When one looks objectively at the important metrics, all of them are in the red; more devastation is to come, much more.

Metric 1: population. We added 2 billion people on planet Earth in the past 20 years alone; 2 billion! Many of these individuals live in hazard prone areas, so we mathematically increase the overall exposure.

Metric 2: assets at risk. As people move out of poverty (a lot remains to be done here) and many more people enter the middle class, they purchase more, then more assets are in harms’ way.

Metric 3: aging infrastructure. This is certainly the case in the US where trillion of dollars of investment are needed just to modernise our fairly old infrastructure.

Metric 4: interdependency. Moreover, our world is more globalised and interdependent than ever before. Something happening 5,000 time away from where we are can have a ripple effect onto us fairly quickly. A massive flood in Thailand, for example, affects the world global supply chain. In other words, we are exposed, directly or indirectly, to more sources of destabilisation.

Steve: Given that risk spreads have declined do you think it could encourage more country or municipality-level risk transfer?

Erwann: Of course. Moving down from 8% to 5% premium is a big difference. ILS also typically provides premium stability over several years, a critical advantage that has been totally underappreciated in today’s highly volatile world. There has been much discussion with insurance companies about whether they would be ready to issue fixed rate insurance contracts for 3 or 4 years and whilst the answer has been ‘no’ as of yet, CAT bonds have provided stability, reassuring to the treasurer of any corporation or city.

Steve: What direction will risk spreads head in, in both the short and long-term?

Erwann: It could go down or up. Down if we are lucky again, if there are no big disasters in 2014 and the financial markets keep moving up. Maybe 50 points or even 100 points. But they could go up again if there is a series of large catastrophes and/or a severe correction of the financial markets affecting the availability and cost of capital.

That said, one also need to be careful not to compare apples to oranges. There are many different ILS products, so spread will of course depend on the nature of the transaction and risk involved.

Steve: What do you see as the challenges of expanding the remit of ILS and CAT bonds to better assist with narrowing the disaster gap globally?

Erwann: Globally the larger question is who should pay for catastrophes. The public or private sectors? And when? Before (insurance) or after (ex post compensation)? How countries and markets respond to these two questions will largely determine the future of the ILS market.

Historically we looked to governments as the ultimate risk managers; that is true even in the U.S, often depicted as the most market-based economy. But if we take the U.S. catastrophes over the last 50 years we see the cost of these disasters increasingly borne by the taxpayers. Consider the following: when Hurricane Diane hit in 1955 only 6% of the aftermath costs were paid by the American taxpayers but by Hurricane Katrina in 2005, this number had risen to 50% and then 80% for Hurricane Sandy in 2012, that’s 80%! Some would say this is hardly a market economy.

Whether this will be the new norm for America, because it would be hard for any future Congress not to follow precedent, is unclear. This could also be a tipping point. This has indeed resulted in elected officials debating as to who should shoulder the responsibility of relief. It took U.S. Congress 3 days to vote $50 billion of relief after Hurricane Katrina in 2005 but for Hurricane Sandy it took Congress 3 months of intense debate to vote for the same $50 billion of relief. What happened in between? A world financial crisis that had severe impact on national debt. Subsequently, if we don’t want taxpayers to carry the cost of future extreme events, we will have to hedge some of these financial liabilities. Players in the supply and demand sides of the ILS market should be at the discussion table.

This reminds me of earlier discussions at Wharton in the early 1990s where the concept of cat bonds was first introduced. Twenty-five years have passed and the market is growing but could be potentially immensely larger. One just needs to be innovative to create value, and a decent return.

Steve: Thank you Erwann for that alternative perspective.

Erwann: It has been my pleasure talking to you.

Transcript end.

Read our other articles and transcripts taken from this report:

– Institutional investor appetite for insurance linked assets remains strong.

– Roundtable: What are the challenges of evolving insurance-linked securities structures?

– Roundtable: What is the future for insurance-linked securities?

– Interview: Tony Rettino on building a sustainable reinsurance model.

– Roundtable: Achieving optimum diversification in ILS investing.

The report from Clear Path Analysis is available to download today.

Visit the Clear Path Analysis website to register to download a full copy of the report ‘Insurance-Linked Securities for Institutional Investors 2014‘ including all of the interviews and roundtables.