U.S. risks dominate ILS, driving price advantage for diversifying perils

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The portion of property catastrophe (P&C) risk transferred to the global catastrophe bond market from North America remains overweight, in part due to a lack of ILS penetration in other P&C markets across the world. And with investors keen for further diversification, non-U.S. exposed deals are expected to have a pricing advantage, according to reinsurance market leaders.

Analysis from reinsurance broker Aon Benfield reveals that 45% of global P&C gross written premium (GWP) comes from North America, while approximately 83% of catastrophe bond issuance in the 12-month period ending June 30th 2016, were exposed to U.S. property risk, down from the 86% reported a year earlier.

The reinsurance broker explains that although the 83% is aligned with international exposures to insured property risk, with the U.S. leading the top 50 global P&C markets in terms of GWP and GWP to gross domestic product (GDP) ratio, the region’s dominance in the cat bond space when compared to the volume of global P&C GWP, suggests its share of risks ceded to the cat bond space is overweight.

“This is, in part, driven by lag in international property catastrophe risk markets to adopt alternative capital risk transfer strategies, particularly in Asia (ex-Japan) and Latin America, where competing with the cost of traditional reinsurance may be challenging,” explains Aon Benfield in its September 2016 insurance-linked securities (ILS) market report.

Absent Japan, of which according to data from the Artemis Deal Directory there are currently nine outstanding cat bond transactions exposed to either Japanese earthquake or typhoon risks, amounting to roughly $2.78 billion of the outstanding market size, ILS penetration across Asia is limited.

The $50 million Panda Re (Series 2015-1) transaction from reinsurer China Re, which covered Chinese earthquake risk is the first and only catastrophe bond issuance to focus on China and, while the volume of diversifying deals has been on the rise in recent times, the U.S. still dominates the marketplace.

The abundance increasingly efficient flow of traditional reinsurance capital suggests that it could be difficult for ILS solutions to compete on a pricing level with some reinsurance companies in emerging markets, like parts of Asia, Africa, and Latin America. This, combined with limited modelling capabilities when compared with U.S. wind risks, for example, has hindered the expansion of ILS solutions and capacity into emerging markets, contributing to the persistent dominance of U.S. risks.

Reinsurance giant Munich Re, in its Q3 2016 ILS market report, also highlighted the continued dominance of U.S. exposures in the cat bond market, while noting a rise in Japanese perils and more exotic exposures in general, in more recent times.

Munich Re’s Q3 ILS report reveals that, generally, the share of diversifying perils (non-U.S. exposed) in the cat bond space has remained at 35% for the last five years.

As a result of this, the reinsurer expects a “continued advantage in pricing for non-U.S. exposed transactions, with investors keen on further diversification.”

Along with the extremely low correlation to movements in the wider financial markets, diversification is one of the key attractions of the ILS sector to its investor base, which is mostly comprised of institutional investors such as pension funds.

As the market continues to spread its wings and influence perils across a wider geography, investors appear to be very eager at achieving further diversification within the asset class and assuming exposures in Japan, China, and so on, with the diversification making up for a lower return, which relates to the “pricing advantage” suggested by Munich Re.

Expanding the utilisation of alternative risk transfer solutions to emerging markets is both a challenge and opportunity for the ILS space, and while increased insurance and reinsurance penetration could facilitate greater ILS participation, understanding the risks via data, models, and analytics will likely be key in achieving successful growth.

Should the exposures in emerging markets become better understood, which is beginning to happen as technology helps to advance catastrophe risk modelling solutions, it’s likely that the investor base will be more than happy to take on diversifying deals that do good for both society and the growth of the ILS sector.

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