Cat bond efficiency has come a long way in the last decade. The premature grey hair and portly reflection that peers back at me in the mirror serves as a reminder of a time when even the simplest deals seemed to take months of work. A whole thriving food delivery industry grew up in the City of London just to keep us fed and watered back when success was measured on capacity to work a 120-hour week, as much as on quantitative ability.
Much has changed since then. Of course, complex ground-breaking deals still take a monumental amount of effort to place successfully—just ask anyone who’s been involved with Metrocat, PennUnion or Bosphorus, and they’ll tell you it’s a very intensive process.
But there’s little doubt that deal issuance has streamlined remarkably. It is now feasible to get a simple deal done in a matter of a few short weeks, and the market knows what to expect in the way of portfolio disclosure and risk analysis information. Indeed, collateralized reinsurance trades have pushed things further, removing some of the more complex structural obstacles to get risk into insurance linked securities (ILS) portfolios efficiently.
This week, I was on a panel at the Securities Industry and Financial Markets Association (SIFMA) Insurance and Risk Linked Securities Conference, discussing the ways in which the efficiency of the cat bond risk analysis could be further streamlined. This topic comes up a lot—a risk analysis can be one of the largest costs associated with a transaction (behind the structuring fees!), and certainly a major component of the time and effort involved.
If there’s one aspect we can all agree on, I suspect it’s the importance of understanding the risk in a deal, and how that deal might behave in different catastrophic scenarios. Commoditizing the risk analysis into a cookie-cutter view of a few well-known metrics is not the way to go—every portfolio is unique, and requires detailed, bespoke understanding if you’re to include it in a well performing ILS portfolio.
Going further, it is often suggested that the risk analysis could be removed from cat bonds—indeed, there’s no other asset class out there where the deal documents themselves contain an expertized risk analysis. Investors are increasingly sophisticated—many can now consume reinsurance submissions and have the infrastructure to analyze these in-house. The argument goes, why not let the investors do the risk analysis, and take it out of the deal—that way the deal can be issued more efficiently. One deal—Compass re II—has tested this hypothesis via the Rewire platform, and successfully placed with a tight spread.
Compass was parametric—this meant that disclosure was complete. The index was fully described, so investors (or their chosen modeling consultancy) could easily generate a view of risk for the deal. This would not have been so straightforward for an indemnity deal—here, as an investor, you’d probably want to know the detailed contents of the portfolio in order to run catastrophe models appropriately. Aggregates won’t cut it if you don’t have a risk analysis. So, for this to work with indemnity deals, disclosure would have to increase significantly.
An indemnity deal with no risk analysis would also open up the question of interpretation—even if all the detailed data were to be shared, how should the inuring reinsurance structures be interpreted?
This can be one of the most time consuming elements of even the simplest indemnity deals. Passing this task on to the market rather than providing the risk analysis in the deal would inevitably lead to a change in the dynamic of deal marketing—suddenly investors would be competing more and more on the speed of their internal quoting process, and be required to develop large modeling infrastructure, far larger than most ILS funds currently have access to today. Inevitably this would take longer and lead to a more uncertain marketing process. Inevitably it must load cost into the system, which might well be passed back to issuers by way of spread or to end investors by way of management fees. Or both. Suddenly the cost saving in the bond structure doesn’t look as attractive.
I believe there’s a better alternative—and it’s already starting to happen. Increasingly, we are being engaged by potential deal sponsors much earlier in their planning process, often before they’ve even contemplated potential cat bond structures in detail. In this paradigm, the risk analysis can be largely done and dusted before the bond issuance process begins—of course, it’s fine-tuned throughout the discussions relating to bond structures, layers and triggers etc. But the bulk of the work is done, and the deal can happen efficiently, knowing precisely how the underlying risk will look as the deal comes together. This leads to much more effective bond execution, but doesn’t open up the many challenges associated with risk analysis removal.
Detailed understanding of risk, delivered in the bond documentation, but with analysis performed ahead of the deal timeline. Perhaps the catastrophe bond analysts of the future won’t have to suffer the ignominy of receiving Grecian 2000 for their 30th birthdays.
Ben and the RMS capital markets team will be talking more about innovation in the ILS market at Exceedance 2016– sign up today to join us in Miami
