Risk models (and data) are key to broadening scope of the cat bond and ILS market

One of the topics we discuss regularly on Artemis is the potential for the cat bond and ILS market to broaden their scope to include new classes of risk and new geographical locations. Broadening the scope of the market by enabling new risks and locations to be included in transactions is one of the key factors which could help the market grow significantly and would appeal to both sponsors and investors, however the available models and data to support them is not yet sufficient in many cases.

Catastrophe bonds and insurance-linked securities, as complex financial risk transfer instruments, are very much dependent on robust risk models which themselves are dependent on the availability of data which underly these models. 144A cat bond and ILS transactions generally require a third-party risk modelling firm to participate in the deal by providing the risk analysis, modelling and also calculation agent roles. By using a third-party modelling firm with no links to sponsor or issuer investors feel comfortable that an outside, expert opinion on the actual risk a security holds can be trusted enough for them to put money into a deal by investing in the notes. Often the sponsor themselves has internal modelling capabilities but lacks the broader, market wide data on a particular risk and also isn’t an external party to the deals, so third-party modelling is the accepted route for bringing transactions to market.

In our recent predictions article where we spoke with rating agency Standard & Poor’s representative Dennis Sugrue, he mentioned that risk models are considered underdeveloped in many of the regions considered as ‘diversifying’. Now S&P have published an expanded version of this piece (available here but login to the S&P website required) with a little more commentary on this issue.

S&P says that given the catastrophe loss experience in many regions considered ‘cold spots’ or ‘diversifying risks’ by reinsurers during 2011 (read Latin America, Asia and Oceania) some re/insurers may turn to insurance-linked securities for protection in these regions. However, S&P says that models for these risks are underdeveloped and they consider this a barrier to ILS issuance.

The same goes for new classes of risk outside of the natural catastrophe arena. The lack of robust third-party risk models can hinder the opportunities for new risks to be transferred to the capital markets as ILS, despite an appetite from investors for more diversification opportunities. There is growing momentum in some classes of risk to enable re/insurers to utilise ILS structures as a way to complement their re/insurance coverage, with initiatives such as the ISO Casualty Index which could help transfer casualty risks to the capital markets in ILS form, CatVest Petroleum Services new EnergyRisk model aimed at the energy sector and Milliman’s involvement in the Vitality Re medical benefit ILS transactions showing the potential for new risks to be included in ILS deals.

Data is the other issue, which is often too scarce for a robust model to be created and used to bring new risks or geographies to the ILS market. Much of Asia has a lack of natural catastrophe and insurance loss data in countries which have significant exposure and this is one of the main reasons we don’t see a broadening of the ILS market in this region of the world. As insurance penetration continues to rise rapidly across Asia, and other regions such as Latin America, efforts to collect or acquire the data needed to support robust models will continue apace and this could bring these regions into the ILS and cat bond market relatively quickly.

The private cat bond trend could also help to broaden the market, although data and models are required to support these deals too. However private transactions can allow for smaller deals to be structured and this can give an opportunity to sponsors to bring a completely new risk to the market using new models. A good example of this was last years Hoplon Ltd. transaction which saw lottery winning risk transferred to the capital markets through a cat bond type ILS deal.

So, as you can see there is room for the markets to broaden their scope, both in terms of risk and geography, and we expect to see more initiatives emerge seeking to help sponsors access the capital markets in new ways. There are other factors which may hinder the expansion, such as investor appetite for certain new types of risk or a lack of sponsor appetite to move away from traditional sources of re/insurance cover. Education can help here, but robust risk models and the availability of data is a key factor which could assist growth and an expanded scope for the cat bond and ILS markets over the next year or two.