If you take the concept of insurance-linked securities (ILS) to its natural conclusion, you’ll wind up at real-time risk and capital management. The insurance and reinsurance community has discussed such a possibility since the early days of ILS, but the reality remains elusive. While ILS offerings have done much to change the face of the industry, some structural challenges continue to impede real-time catastrophe risk trading.
Two fundamental factors prevent such trading: supply and liquidity. Quite simply, there has to be enough supply and enough market participation to let traders easily enter and exit positions.
Transaction supply has increased but continues to fall short of demand. The major reinsurance intermediaries put the amount of ILS outstanding at more than $40 billion. While that does speak to increased adoption of ILS, it’s not nearly enough to meet apparent investor demand. If the global pension fund sector committed only 0.5 percent of its $30 trillion in assets under management (according to Towers Watson data) to the ILS sector, the amount of catastrophe bonds outstanding would have to double (and then some) to absorb the inflows.
Absent a significant increase in deal flow, would-be entrants must remain on the sidelines, and a robust market for real-time catastrophe risk can’t develop. We need scale, and that only comes with more opportunity to trade.
Constraints on market size also hamper liquidity. While some ILS vehicles (such as catastrophe bonds) have increased the liquidity of catastrophe risk, the limited supply of transactions has impeded rapid growth. A greater amount of capital in the ILS space would naturally increase liquidity, bringing real-time catastrophe risk trading closer to reality. Of course, that capital would need somewhere to go, which points to the supply shortfall.
So, to reach a real-time catastrophe risk trading environment, one of two things needs to happen: Either issuance must increase, or an alternative instrument must emerge. While continued issuance growth appears likely, it will have to tie to the needs of sponsors. They aren’t likely to issue more ILS simply to make the market bigger. Rather, they sponsor transactions based on their specific needs to transfer risk and optimize the deployment of capital.
Bespoke synthetic catastrophe risk products, on the other hand, are a possibility. But they would come with frictional costs that could prevent wide adoption and limit market efficiency. In fact, such transactions have occurred — but only to a limited extent.
An instrument, therefore, would have to be well known, inexpensive to launch and maintain, and easy to trade on an exchange. Such an instrument must also directly reflect insured losses from catastrophe events.
In the mid-1990s, Property Claim Services® (PCS®), a unit of Verisk Analytics, developed an index that facilitated trading of catastrophe insurance options on the Chicago Board of Trade. But that product came well before corresponding demand existed. Since then, the situation has changed drastically. Today, the need to trade options based on an index — such as the PCS Catastrophe Loss Index — is palpable. Such trading would let the entire ILS community, including potential entrants, participate in the market regardless of access to ILS deal flow.
Using its existing technology and resurvey process, PCS could supply daily catastrophe loss updates to participating exchanges, making the results available to investors — who could trade right off the screen.
Demand for catastrophe risk investment opportunities has never been greater, and the need for an additional outlet for capital is clear.