Ready for Exchange-Traded Risk?

By Tom Johansmeyer  |  September 15, 2015

Recent changes to the range of capital markets risk-transfer solutions available to cedents — and their adoption of them — show insurers and reinsurers are committing to more sophisticated strategic capital management. However, plenty of room for innovation remains as the industry continually seeks an edge in creating shareholder value.

The insurance-linked securities (ILS) market looks much different than it did a few years ago. Recovering from the global financial crisis of 2008, the catastrophe bond market began a steady ascent, culminating in several record-setting quarters and years before seeing its first dip in 2015. Collateralized reinsurance use has surged, and industry loss warranties (ILWs) have gone in and out of — and once again in — favor. The risk-transfer solution mix has evolved, with the tools available supporting more targeted risk and capital management decision making. The more traditional catastrophe bond market appears to be settling into a groove of larger transactions, indemnity triggers, and publicly managed entities — three factors that fit well together. On the smaller side of the market, cat bond lite adoption has risen rapidly, with index triggers frequently featured and a lead time for execution that can be as short as ten days.

So, what comes next?

In the corner of the market focused on speed, efficiency, and cost-effectiveness, a discussion about exchange-traded risk is bound to arise. It really does seem to be the market’s next logical step.

Over the past couple of years, my colleagues and I have invested a lot of time brainstorming the concept of exchange-traded risk and how it could work. Moments of pure excitement at a potential breakthrough have been punctuated with the most profound frustration as we encountered seemingly immovable objects in how capital markets catastrophe risk transfer occurs.

Intuitively, the notion of exchange-traded risk seems to make sense. Who wouldn’t want the ability to manage risk and capital in real time? It seems as if it should be easy to execute, but reality can be brutal. Over the past 25 years, several attempts haven’t been able to deliver. Nevertheless, conversations across the market have revealed that demand for an exchange-traded solution is significant.

Several developments seem to suggest the viability of an exchange-traded risk solution. “Live cat” cover, comes to mind immediately. For events that develop over time (such as tropical storm), there’s enough lead time to stimulate trading activity. And the “dead cat” period that follows could continue the trading cycle for months — or even more than a year for large, complicated catastrophe events. However, with only $9.3 billion in North American catastrophe events so far this year, there’s been little opportunity to gauge the need within the context of a sufficient loss.

The cat bond lite market may provide more insight, especially given its increasing penetration of the traditional reinsurance market. This market provides a source of original risk to be transferred, with a focus on speed and minimizing frictional costs. The historical focus on fund-to-fund transactions could make cat bond lite users an effective test market, given the propensity for innovation and interest in minimizing expenses for tactical risk transfer.

The difficulty with both scenarios, however, is scale. Cat bond lite serves a rapidly growing market, but it’s still fairly small. Live cat/dead cat requires a major catastrophe event (the last one was Superstorm Sandy) and still represents a relatively small portion of the capital already in the market — let alone global pension fund assets with a target allocation that could be as high as $900 billion. To succeed, an exchange-traded risk solution will have to overcome the current ILS market constraint of needing a source of original risk to bring to market. The market is thinking about it. And when that happens, a solution is bound to follow.

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Tom Johansmeyer

Tom Johansmeyer is Assistant Vice President – PCS Strategy and Development at ISO Claims Analytics, a division of Verisk – insurance solutions. He leads all client- and market-facing activities at PCS, including new market entry, new solution development, and reinsurance/ILS activity. Currently, Tom is spearheading initiatives in global terror, global energy and marine, and regional property-catastrophe loss aggregation. Previously, Tom held insurance industry roles at Guy Carpenter (where he launched the first corporate blog in the reinsurance sector) and Deloitte. He’s a veteran of the US Army, where he proudly pushed paper in a personnel position in the late 1990s.