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Sub-prime comparison not fair to catastrophe bonds: John Seo, Fermat


The recent comparisons that have been made between catastrophe bonds and sub-prime, or toxic, mortgage-backed securities, are unfair to the cat bond market, where to date the bundling of non-transparent risks is not an issue, according to John Seo.

The Co-Founder and Managing Principal of specialist insurance-linked securities (ILS) and catastrophe bond investment manager Fermat Capital Management, Dr. John Seo, has responded to recent reports where parallels have been made between cat bonds and sub-prime mortgage securities.

There have been recent criticisms that catastrophe bonds contain complex, non-transparent bundles of reinsurance risk. Seo notes that the reinsurance market does feature opaque instruments and therefore “it is easy to see how market commentators are piecing together snippets of information to draw hard conclusions on industry developments.”

“Such conclusions have subsequently misleadingly been linked to cat bonds,” Seo explains.

“The fact is that the bundling of non-transparent risk is not currently impacting the cat bond market,” he continues.

Seo goes on to explain that the reinsurance industry does involve the bundling of risks, but that they are passed on to “professional parties which are capable of assessing and setting upper bounds on the levels of exposure they are taking on.” As a result Seo believes they are making “informed purchase decisions.”

The market is not seeing any trend towards bundling and disguising toxic risk assets in order to sell them to unsuspecting parties, according to Seo, and these complex risk-bundles are only accessible to professional industry participants.

“They are not being sold in the securities market to unsuspecting investors. To link reinsurance risk bundling to subprime debt is a misinformed comparison,” Seo states.

It is indeed true that the cedents behind complex reinsurance transactions, which perhaps bundle up multiple lines, perils or business units risks into single large layers or risk, want to transact with professional and experienced reinsurance counterparties.

Hence the very large and sometimes visually opaque to outsiders reinsurance deals that have become more of a trend, as buying habits have changed among large insurers, typically end up in the hands of many of the world’s largest reinsurers or specialist ILS managers.

Bundling of risk is actually reflective of a larger, positive industry trend, Seo explains, adding that it goes hand in hand with greater retention of risk by cedents.

“If global insurers were not retaining more risk, but merely re-packaging it into more complex packages, then we could see a potential, systemic issue on the cards. However, global insurers are not just re-packaging their risks; they are radically restructuring how they self-manage their risks,” Seo said.

The world’s largest insurance companies have shifted their reinsurance buying from income protection or capital protection, according to Seo, which results in insurers retaining more risk to minor losses while increasing their solvency protection.

In Seo’s view, this means that insurers are “increasing, not decreasing, their responsibility for their underwriting choices.” This trend of retention has also seen insurers focus on minor catastrophe zones, where the specialist reinsurers of the world operate, adding to the pressure these players have felt lately.

Seo highlights that this trend has also been driven by the adoption of risk models, better data and enhanced actuarial capacities at large insurers. Even AIG lacked in-house risk modelling expertise in-depth as recently as in 2010.

At the same time insurers are buying more reinsurance capacity for the very large catastrophe events, often driven by regulations such as Solvency II. This puts the increased demand into the domain of the catastrophe bond markets and very large reinsurers.

“In a sense, large insurance companies are literally outgrowing all but the largest reinsurance companies,” Seo said.

“The bundling trend is therefore part of a larger industry shift toward more self-reliance on the part of global insurance companies, which we view as a responsible, positive development.

“Global insurers are now able to internally consolidate more of their risks thanks to their vast size and greater business diversity, retaining more risk, then reinsuring for losses at the global company level in both the reinsurance market and the cat bond market,” Seo continued.

This does mean that reinsurance companies are faced with complex portfolios of risk to evaluate, that is part of the job. However, Seo notes that “truly catastrophic” risks are located in a small handful of peak geographic zones and typically in developed markets and the U.S., cat bonds are not called on to cover obscure parts of the globe yet.

Seo goes on to explain that smaller, specialty or mono-lined reinsurance firms can see cat bonds as a root cause for the pain they are suffering, which has often been created in the first place by changing market trends and also excess capital in the traditional markets.

“Cat bonds are certainly not helping specialty reinsurers, but the real problem is the secular shift in the reinsurance buying habits of large insurance companies, which historically have been the best customers for specialty reinsurers.

“Cat bonds, with their exotic and esoteric reputation, seem to have become the unfortunate scapegoat for the misinformed,” Seo said.

Seo goes on to discuss the size of the cat bond market saying that, with around 135 outstanding cat bonds and a small market size compared to other asset classes, it would be hard to hide “alleged bundles of rogue investments” in a modest pool of assets of that size.

The risks are highly focused, clearly specifiable and modelable and the liabilities they represent stop with the insurer, not with the investment community. The maximum loss an investor can expect to suffer is the value of the cat bonds they hold, explained Seo.

“While not comparable to pre-crisis subprime MBS, cat bonds are a sophisticated and complex asset class not suitable for all investors and portfolios,” commented Seo.

Losses are to be expected and they can be large, therefore investors are encouraged to enter this market with eyes open and aware of the risks they take on.

Seo makes good points. The bundling of risks is really more apparent in some areas of traditional reinsurance, but as he said this is the domain of risk professionals who are highly skilled.

Many of the issues with sub-prime mortgages were linked to a systemic failure in the governance of that financial market and also the conduct of certain market participants.

Naturally, there is always a possibility that bad actors could seek to bundle risk to a degree that issues arose, and this could happen in reinsurance, as well as in the catastrophe bond market, or indeed any other financial market.

However, it is to be hoped that market participants are aware of the key role they play in providing the world’s disaster risk capital, the importance of protecting it and of following best practice in risk transfer, in ensuring that risks can always be analysed, quantified and modelled as best they can.

Risk can be bundled, packaged, wrapped up, transferred and sold. But the market should always attempt to ensure that it is done so responsibly, that parties understand what they are buying into and that the underlying exposures are accurately reflected in the deal terms, risk profile and pricing.

Also read: Discipline improves cat bond yields, market continues growth: John Seo.

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