Protection gap the biggest opportunity for alternative capital: Seo

The protection gap, consisting of areas of under-insurance or in some cases no insurance protection at all in both mature and emerging markets, is the biggest opportunity for alternative reinsurance capital, ILS and capital markets to play a role, according to Fermat Capital’s John Seo.

Speaking at the 2015 Bermuda Reinsurance conference, hosted by PwC and Standard & Poor’s this week, John Seo Co-Founder and Managing Principal at cat bond and ILS specialist investment manager Fermat Capital Management LLC, discussed the need for more capital to help fill the gap between economic and insured losses, as well as to protect against risks that are completely unprotected today.

The capital markets entry into reinsurance, as third-party capital providers backing catastrophe bonds and other insurance or reinsurance linked securities structures, was a response to the realisation that some peak risks are so potentially large or systemic that additional, efficient capital was required.

Of course the ILS wave and the ingress of the capital markets, as it has converged with traditional reinsurance, has become a much more broadly felt trend that has resulted in ILS players performing the jobs of reinsurers and even trying to access the sources of risk.

But the initial thinking behind ILS and the capital markets relevance to insurance and reinsurance still stands, with the depth and liquidity of global capital markets seen as the only way to narrow or fill the protection gap, as well as to begin to protect huge areas of risk that today are completely unprotected against.

Speaking during a panel discussion on the developments of alternative or third-party capital, John Seo said that he sees alternative capital as complementary to traditional insurance or reinsurance, particularly when it comes to covering these gaps and under-insured areas.

“The protection hap is really, I believe, the biggest place that alternative capital will play,” he explained, continuing to say “The protection gap by definition is actually systemic risk, these are risks that are so big from single events that they just can’t all possibly be covered.”

“I think how it’s going to break out is that you’re going to see more alternative capital providing coverage on an index or parametric basis.”

Seo said that despite the shift towards indemnity triggers, which has been a function of the market to a degree, his expectation is that areas of under insurance, or zero insurance, are ripe for indices and parametric triggers to provide coverage.

“I really do believe that long-term you’re going to see more of a role for parametric. Really if you look at protection gaps, they’re a natural side-effect of having a service economy. More of our economic loss is occurring through business interruption, less on the physical damage side,” he said.

Seo went on to explain that basis risk is often a misnomer, when triggers are discussed. That in insurance gaps, under insurance and areas that aren’t insured at all, it’s not right to call it basis risk if the risk isn’t covered or hedged in the first place.

He continued, saying that we are unlikely to ever fill the protection gap completely, but we can do better than we are today. Approaches to filling the protection gap using traditional methods aren’t always effective, according to Seo.

“Right now I’m afraid that how we’re trying to fill the protection gap using tradiitonal methods is just confusing the customer,” he commented.

Seo said he could envisage the need in the future for tens or maybe hundreds of billions of dollars of additional capacity on the coastline to protect the true levels of risk, provided on a parametric basis and “Our market is absolutely thirsty to provide that capacity.”

This goes right back to the beginnings of ILS and the use-case for catastrophe bonds, which were seen as the best way to transfer the peak risks of the world to capital that could afford to bear it, for a fee.

The panelists agreed that one issue that comes up repeatedly is that in order to narrow the protection gap you need to sell insurance, or risk transfer, to people and to cover risks that have never bought protection or been covered before.

Seo discussed the issue with building functioning insurance markets in emerging economies, which can result in fragile systems, take decades to achieve and result in claims and other issues. The parametric trigger, or other indices, can be put to work in these scenarios immediately.

Again, Seo said that basis risk when it comes to the protection gap “doesn’t have any meaning.”

“It’s a modern western concept when you’re talking to people who are striving to be fully-covered for everything. It’s a misused term, in the protection gap, whether its emerging market or here in the U.S.”

As alternative capital and ILS investors increasingly look for new opportunities, the protection gap is clearly one area that has the potential to require significant capacity and could be a real opportunity for investors to significantly grow their allocations to the asset class.

It will require a change of mindset, as Seo alludes, to triggers, structures and issues such as basis risk. In a similar way insurance markets in emerging economies may not develop in the way that the traditional re/insurance market expects and that may lead to opportunities for the capital markets to further grow its influence.

Read our series of articles focused on the insurance protection gap – under-insurance in emerging and developing economies, the gap between economic and insurance losses, and transferring risk from public sector to private – the opportunity that is on every reinsurance CEO’s lips and which presents the largest opportunity to put excess risk transfer capital to use, requiring both traditional and capital markets support.