The use of parametric triggers in catastrophe bonds are the best path to a sustainable, lower cost of capital and towards realising the vision of the cat bond as a robust asset class, Samir Shah, Head of Capital Markets and Catastrophe Risk at AIG, told Artemis.
Discussing the recent completion of the unique six month term, parametric trigger, $300m Compass Re II Ltd. (Series 2015-1) that AIG sponsored recently, Shah explained a little of the insurers thinking behind adding the cat bond to its reinsurance and risk transfer program structure.
Shah also discussed his thinking on the use of parametric triggers in catastrophe bonds, something that he believes could result in a stronger ILS asset class.
Explaining why AIG elected to sponsor a six month transaction, in the Compass Re II cat bond, Shah said; “Given the seasonality of windstorm exposure, a six-month cover should be more efficient for collateralized risk transfer like a cat bond – it frees up collateral when not on risk.”
He also noted that a six month transaction may across the wind season may also be more appealing to ILS investors, commenting that “investors will get their collateral back in time to redeploy for year-end offerings.”
That’s an interesting point. It has to be considered that some investors may provide a sponsor with a better cost or price if three six month transactions for U.S. wind seasons, running June to end of November, were issued over one three-year deal which locked up collateral for the entire period.
Investors could feasibly put that collateral back to work in other transactions during the December to May period.
AIG has been more typically associated with indemnity catastrophe bonds, through its Tradewynd Re series of deals in more recent years. These transactions have become increasingly more complex, as AIG has sought more coverage for its commercial insurance business exposures.
Shah discussed how AIG views the indemnity protection versus the six month parametric cover provided by Compass Re II.
“The Tradewynd bonds are in support of our corporate property cat reinsurance program that is focused on achieving our risk management objectives,” he explained of the indemnity transactions.
With Compass Re II, AIG’s objectives were different, Shah continued; “This parametric bond is focused on the value of realizing a potentially lower cost of capital over the long-term vs. our internal cost of capital.”
With a parametric trigger it is key to create something that is responsive, measures the right attributes of the event and that fits neatly with the protection buyers needs.
Shah explained that AIG wanted to stay true to the simplicity of the parametric trigger, saying; “The trigger requirements were typical of any successful index: few parameters, reliable reporting of parameters by recognized independent third party, long historical record for parameters, simplicity in structure/calculation.”
The parameters used in Compass Re II allowed AIG to calibrate the trigger to be most responsive in areas where a landfall is expected to cause a greater loss to the insurer, thus helping to reduce basis risk from the sponsors point of view.
To achieve that the event index value was weighted by location of landfall, meaning that AIG could apply higher weighting to coastal areas where its exposures are greatest.
After creating the index and trigger design, “Within those constraints, we optimized to best match our exposure,” Shah commented.
We asked Shah how investors had responded to the unique aspects of the cat bond.
He replied; “Although I haven’t had a chance to debrief with investors, from the order book, it seemed that the investors were pleased with the overall offering. It’s difficult to say at this point, how much value they attributed to each structural component. I hope to get a better sense of that off-season.”
Given that the deal terms and structure are new to AIG, Shah said that the insurer would review the transaction after the wind season, to assess its popularity and effectiveness.
“We will not decide until after we have had a chance to discuss with investors and complete our analysis,” he noted.
Shah then explained that it is his belief that parametric coverage could play an important role in AIG’s risk transfer and capital provisions going forwards; “I believe that parametric offers the best path over the long-term to a sustainable, lower cost of capital.”
Shah continued; “I believe that parametric offers the best path towards realizing the vision of cat bond as a robust asset class – one in which a broader range of fixed income investors participate, the asset class is a standard component of strategic asset allocation of institutional investors, more liquidity, standardized rating system, better price discovery and more efficient execution.”
Those words will resonate with many of the large institutional investors in the ILS space who often bemoan the lack of parametric investment opportunities in the asset class. Many large investors such as pension funds would prefer to see a steady stream of parametric deals, rather than complex indemnity which requires more resource to analyse and typically requires the help of specialist managers to underwrite.
The Compass Re II parametric cat bond experience has clearly been positive and Shah sees it as a key stepping stone in AIG’s move to leverage lower cost and more efficient sources of risk capital.
“I am very pleased with the outcome and look forward to engaging with investors on how to move this market forward on the path towards a robust asset class,” he concluded.
You can find details on all of AIG’s previous catastrophe bonds, including the Tradewynd Re series and the most recent parametric deal Compass Re II in the Artemis Deal Directory.