How ILS can rise up to global terror risk

Fomenting a reinsurance revolution isn’t easy. Everyone wants change, but what that means is as varied as the people calling for it. So, when there’s a sign of consensus, immediate action is always best, writes Tom Johansmeyer of PCS, Verisk Insurance Solutions.

It doesn’t happen much, but when the market called for an independent global terror loss index, the PCS team knew it was time to act. Market dynamics over the past several years have made the need for cost-effective terror risk transfer acute, and absent a mechanism or industry loss warranty (ILW) trading, cedants  have been short on alternatives.

The collective concern about terror

Until a handful of major catastrophes struck the US in 2017, the global property-catastrophe reinsurance market seemed to become more flexible with every renewal. As rates sought a floor, capacity providers tried to hold the line on pricing by including other risks in their natural catastrophe programmes—ironically, some of them not so natural.

Increasingly, terror was included as something of a value-add, meaning that reinsurers took on the risk without being compensated for it. And that’s a formula for unmanageable accumulation.

For several years, I’ve heard a lot of concerns about terror. A few years ago at the Rendez-Vous de Septembre in Monte Carlo, a player in the market said to me: “I don’t know what my accumulations are, but I know I’m fine now. I doubt I will be next year.”

That’s paraphrased of course, but the sentiment is pretty clear, and I remember it vividly. Terror accumulations were getting too high, and reinsurers were starting to feel the need for some retrocessional protection.

Dealing with it isn’t so easy. It never is.

Global terror has a couple of frustrating factors. The first is that (thankfully) major insured loss events are infrequent. Using data from PCS Global Terror, it can be seen that only 14 events with an industry loss of at least $25 million have occurred since 1992. Only three of them have topped $1 billion (unadjusted for inflation). It’s difficult to understand the risk for the global insurance industry.

Additionally, reinsurers have assumed the risk without being compensated for it. That means there really isn’t any premium income to dip into to pay to transfer the risk. Managing risk and capital therefore becomes a bit more expensive than it would be normally.

At every link in the risk and capital supply chain worldwide, terror poses a problem. Some capacity providers have appetite for the risk, but the transaction needs to occur in a way that manages the costs to the cedant with the expectations of the market. ILWs can make a difference here.

The risk transfer revolution starts now

In an effort to move global terror risk off their books, cedants have tried to engage in ILW transactions. The speed and efficiency afforded by this approach can be attractive to both sides of the trade. However, it only works when there’s an independent third-party trigger that both parties can accept.

PCS has done this for the US for nearly seven decades, but nothing has been effective worldwide and the market has made clear the need for a solution.

In the fourth quarter of 2017, demand became palpable. Pent-up demand for an independent loss index for global terror drove the market to seek a new solution, which is why we accelerated the development and launch of PCS Global Terror (which went live in January 2018) . Currently, several potential global terror ILWs are being explored and negotiated, which means the first trade could be right around the corner.

The insurance-linked securities (ILS) market is prepared to assume global terror risk, although the sector has had an uneasy relationship with it. Some funds, based on the nature of their end investors, are unable or unwilling to take terror.

Others, though, have written plenty of terror programmes because they’re remote and diversifying. Global terror may not have the potential scale of cyber, but few classes of business could grow to rival US property-catastrophe risk. That said, there’s a clear challenge in the market, and there’s enough interest from the ILS sector to make a difference.

As cedants and markets seek new risks and opportunities for growth, terror offers a near-term possibility for growth that solves a clear problem in the market.The timing of the reinsurance revolution couldn’t be better. As cedants and markets seek new risks and opportunities for growth, terror offers a near-term possibility for growth that solves a clear problem in the market. The recent launch of a global, independent industry loss index was the last piece needed to make effective risk transfer a reality.

Demand for the market to rise up

The discussions are happening now. Across the industry, insurers and reinsurers are looking at ways to move global terror into the ILS space. Past efforts ran into difficulties on price. Unique approaches—such as triggering on the number of fatalities from an event—showed promise, but they introduced too much basis risk into the trade. An industry loss index, however, reduces the basis risk involved while still offering the speed and efficiency of the ILW structure.

Further, several of the ILS funds interested in global terror have expressed a preference for PCS triggers over traditional reinsurance placements.

The only step remaining is to do the deal—and that’s in progress. Once the first truly global terror ILW on an independent trigger is completed, look for this market to grow into a robust environment that allows cedants and markets to manage their capital more effectively.

As we usher in the reinsurance revolution, the management of terror risk should prove to be an important early victory.