11 September 2017 Insurance

‘Pre-emptive finance’ deals in pipeline

The insurance-linked securities (ILS) market is entering a new phase of innovation as investors seek new risks and issuers seek innovative solutions that are beyond the means of traditional reinsurers to deliver.

That is the view of John Seo, managing partner of investment manager Fermat Capital Management, one of the oldest and largest ILS fund managers in the world. Seo noted that a number of new risks have been securitised in recent years including new cat risks such as Italian earthquake risk (Unipol), mortgage risk (AIG) and operational risk (Credit Suisse).

But the more exciting development is deals that are structured so that funds are released to help mitigate and control losses before a disaster has run its course.

“The re/insurance markets are not wired that way. They want to see losses and pay out afterwards; in contrast, the capital markets are willing to consider this,” he said.

This was the structure of the recent ILS issued by the World Bank designed to cover the risk of a pandemic globally by providing funds to the Pandemic Emergency Financing Facility, which supports affected countries financially in the aftermath of an outbreak. Crucially, the trigger is designed so the bonds pay out at an early stage of such an event, meaning that the funds can be used partly to prevent further spread.

“This is fantastic,” said Seo. “It is what I would call pre-emptive finance or pre-emptive coverage. Coverage of this type can save lives, as opposed to simply paying out after all the damage has been done.”

There are other beneficial applications of this ideology, Seo suggested—another risk potentially suited to such a structure is cyber, where a deal could be structured to help mitigate the scale of the catastrophe.

“I could imagine a scenario where if security systems are breached in a certain way, a payout could help limit the damage,” Seo said. “It could pay for the business interruption losses of a company taking its systems offline while it solves the problem, for example. Again, that would be pre-emptive finance.”

Seo explained that innovative deals such as this would usually be driven by a sponsor trying to solve a specific problem. Deals that could bring pre-emptive finance to bear for business interruption or cyber risks are being looked at by risk managers and potential investors working directly with each other.

Seo also argued that the current high levels of ILS issuance represent a structural change in the market, as opposed to being driven by specific pricing considerations.

“We are seeing issuers and investors become comfortable with ILS as a generalised technology—and it is not limited to certain catastrophe risks. That can drive innovation for the market.”

“Demand from investors has been high for some time, but the supply side is now picking up. The last time issuance spiked was 2014, which was attributed to attractive pricing relative to reinsurance. It is different this time: this is not opportunistic, this is issuers committing to ILS as a core part of their programme and that means a more structural change.”

He predicts that the ILS market’s capacity will remain stable in the aftermath of big losses—something that could be tested during the current hurricane season.

“ILS investors are doing this because they want to be as diversified as possible. That is the whole premise of the market and they have the deepest pockets in the world,” he concluded.

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