Faced by increased frequency of severity of cat losses, including secondary perils and unmodelled risks, the ILS sector should embrace the opportunity presented by climate change and invest in resources to better understand the exposure and meet rising demand, according to #ReinsuranceMonth panellists.
Participants highlighted the challenges for ILS funds and their investors over the last four years, with the sequence of mid-sized cat losses from primary and secondary perils leading to poor results, notably in the collateralised reinsurance and retro space.
The issue of unmodelled or under-modelled cat events has also been a driver of losses and cause for concern among investors, some of which have suffered from trapped collateral for several years in a row.
Aon Securities CEO Paul Schultz said that market participants are trying to get their arms around a sustainable way to approach the issue of climate change and haven’t yet come to a consensus.
But they should not consider turning away from the risk, and instead meet the opportunity it presents head on to grow the sector, he argued.
“As we continue experiencing a higher frequency of even mid-sized losses, that’s just going to increase the demand for the product. So the industry is well-motivated to figure this out, to try and figure out where the intersection between demand and supply is.
“At the same time, we know that we can’t fundamentally just start excluding because if we do, the value of our product just starts to deteriorate and the value proposition to the buyers goes down immeasurably,” he cautioned.
Commenting on the same panel, TigerRisk Capital Markets & Advisory’s global head of ILS and capital solutions Philipp Kusche said the purpose of the industry is in providing solutions to transfer risk.
And he suggested that there are multiple tools already being used by market participants in response to loss activity, including pricing, portfolio construction and hedging.
Investors are increasingly focused on ILS funds’ approach to risk selection and ensuring that perils are adequately assessed and that data is collected to help in that risk selection, Kusche added – a focus that should lead to innovation in the sector.
“Putting structures in place which are transparent and where investors can have a clear understanding on quantifying the risk is going to be important and key.
We would expect the market to find solutions for it rather than trying to completely avoid it, as a constructive dialogue is what the industry is looking for and necessary to continue to make ILS meaningful,” he commented.
Pillar Capital Management CEO and chief investment officer Stephen Velotti said that pricing and understanding the risk, as well as taking a long-term approach, are key to managing climate change exposure, which so far is manifesting itself in secondary perils, rainfall and flooding.
More generally, he said that for an ILS manager facing industry losses, it was important to ensure that claims are in a “reasonable band” around expected losses for a particular type of event.
“Then you know the portfolio is priced appropriately and it’s going to make money over the long term, you just don’t make money in that month, or quarter, whenever it occurred,” he commented.
And Axis ILS global head Chris Caponigro said investors should not be surprised by cat events and should instead focus on pricing risk correctly.
“Whether we have $100bn of loss in a year, $50bn of loss in a year, it’s our job to just get it right from a cost of goods sold.
As long as we’re pricing cost of goods sold, it’s irrelevant how many losses or how big the losses are in any given year because that’s the business we’re in.
“You have to look over the course of years, factor in all the changes we’re seeing, the severity, the frequency of different perils, whether it’s first or secondary perils in a given year. And as long as we do that well, investors will back us and back the industry,” he said.
Education, education, education
The panellists agreed that investing in understanding climate change and other drivers of secondary perils or unmodelled risks would be key to the sector’s ability to attract more capital to the risk.
Schultz said that he expects significant progress to be made as market participants increase their focus on climate change.
“I feel like partnerships that look fundamentally at what’s happening globally in terms of catastrophic activity are going to make us more educated and are going to help inform us,” he suggested.
Caponigro said with secondary perils and unmodelled losses at the forefront for underwriters, risk modellers and investors, the sector simply needs to devote more resources.
“Long term, we need more investors, more human capital coming into this industry, smarter ways to approach the risks and more R&D. That’s really what it comes down to. We can solve any problem, it’s just a matter of throwing enough resources at it,” said the executive.
Velotti added that while cat models are a good starting point for assessing risk, they are not the answer.
He suggested that underwriters should maintain big databases of their own claims data to compare with expected losses from cat modellers over time and help inform their own view of risk.
For Schultz, the opportunity is there for the industry to get better educated and use that knowledge to pass on to clients to help generate additional demand for the product.
“When you take a look at what’s out there and the opportunity for the industry to respond in a way that isn’t taking unquantifiable risk but doing it in a way that’s educated and a balanced return on that risk, I think we’re going to certainly see greater involvement from ILS,” he concluded.
Is cat an alpha or beta product for ILS funds?
Speaking on the panel, Aon’s Paul Schultz asked whether the access ILS managers offer investors to cat risk as an asset class should really be considered as an alpha product or a beta product.
“All the events that go through the marketplace likely hit most of the managers. So by definition are you really creating alpha, or is it some sort of smart beta product?
“I’ll just put it out there because I think that could change the way that capital starts to flow into the industry around cat as we go forward,” he said.
Pillar Capital’s Stephen Velotti observed that because most cat business is placed and written on a subscription market basis all participants typically get the same price.
But on particular transactions there may be a broad disparity in what is an appropriately priced deal and what is not, with ILS managers choosing which to participate on based on their view of pricing.
“There are plenty of deals that are woefully underpriced that I’ve chosen not to participate on but somebody else did.
“So the alpha really comes from deal selection and not necessarily coming up with a funky structure and trade that nobody else thought of, it’s selecting more of the better risks as opposed to the underpriced risks,” said the executive.
He added that if it was only a beta play, the results of all participants would be in a similar band when events happen, and that is not the case.
“But it is a subscription market so part of Paul’s comments are legitimate. If it was all non-concurrent terms, and Paul, feel free to turn the market into non-concurrent terms, we’d be more than happy to play in that world,” Velotti commented.
Also on the panel, Axis Re’s Chris Caponigro said his company is a “tactically priced shop for all risks”, leaving an opportunity to generate alpha returns.
“We would be stockpickers, and I think if investors talk to managers and look at things like access to business and the declination rate, that is a very important characteristic. If a manager is not seeing the total market, they couldn’t even be beta, let alone alpha,” he added.
Caponigro said that managers of small funds could struggle, but mid-sized funds have the opportunity to be selective and “curate” a portfolio of risks in line with tactical pricing that can deliver alpha returns.
Conversely, the largest players in property cat “can’t help be more beta”, he argued.
“It’s just inevitable. You can’t underwrite around that. The correlation to being beta in the market is just too big,” said the executive.