Triggering a rise in cat capacity
Perils’ Darryl Pidcock discusses the importance of industry loss triggers in supporting the sustainability of the cat market.
Industry loss triggers are playing an increasingly important role in international retrocession markets as protection buyers become more sophisticated in managing their cat risk.
The ILS market has experienced a record year with over $10bn in new transactions and over $40bn in risk limits outstanding. This has been driven largely by US primary insurer cat issuances. Most of the US primary sponsored issuances have used indemnity-based or ultimate net loss triggers, which theoretically have zero basis risk.
For retrocession buyers, i.e. reinsurers or ILS funds buying reinsurance, the need to disclose proprietary portfolio information, which is often highly complex and constantly moving, can present challenges. Moreover, the analysis of such complex reinsurance portfolio data presents significant uncertainties in terms of risk assessment and the determination of the expected loss costs.
Industry loss triggers, in particular structured triggers, require much less disclosure for the protection buyer while the risk assessment is more straightforward and transparent. Protection buyers can structure the industry loss trigger with different weights per geographical area (e.g., countries, Cresta zones) or line of business (e.g., personal lines, commercial lines) which reduces the basis risk of the transaction through better alignment with the buyer’s underlying portfolio. This can be attractive to both protection sellers and buyers as the risk assessment is well understood, disclosure requirements are manageable, and basis risk is acceptable.
For 144A ILS transactions, there is the added benefit in secondary trading whereby transactions using industry loss triggers have demonstrated higher liquidity compared to other trigger types. Investors are often attracted to issuances with simpler and more transparent loss triggers.
Where Perils acts as the reporting agent, 80 percent of the cat capacity transacted as a proportion of total limits has used structured industry loss triggers, which helps to significantly reduce basis risk for protection buyers.
Structured vs non-structured industry loss triggers
Structured industry loss triggers use different weights per geographical area or line of business, providing an efficient means to lower the basis risk in industry loss-based risk transfer. Based upon Perils-based limits at risk as per 1 August 2023, 82 percent of the capacity uses structured industry loss triggers.
While a lot of alternative capital is focused on US primary cat exposures, at Perils we are seeing increasing use of industry loss triggers for retrocession purposes for other peak cat markets such as Europe and Japan.
We have also observed recent interest from retrocession buyers in non-peak cat markets in using industry loss triggers, likely because indemnity-based structures are less attractive to investors because of the aforementioned challenges with portfolio data and risk assessment. Underlying this trend is the fact that industry loss triggers are to date the most widely used non-indemnity trigger in the alternative risk transfer market.
Many market forecasts expect the supply of traditional reinsurance and retrocession capital to remain restricted for the foreseeable future. The use of industry loss triggers becomes increasingly important as risk protection demand exceeds supply of capital. Such triggers can help protection buyers to access retrocession capacity, reduce basis risk and offer efficiencies by simplifying the risk assessment process, while also offering greater transparency to the protection seller. We believe such structures can benefit protection buyers and sellers in creating a more sustainable cat market.
Darryl Pidcock is head of Perils Asia-Pacific