Insurance-linked securities (ILS) are most commonly known for their exposure to natural catastrophe risks such as earthquakes or hurricanes, however there is a small and lesser known category of ILS exposed to what might be termed exotic or man-made risks, for example, pandemic, terrorism or cyber risk. These tend not to be core weightings in a typical ILS portfolio and some investors are understandably uncomfortable with exotic ILS risks. Therefore, we thought it pertinent to consider the question: why bother with exotic risks at all?
ILS investment principles
The answer first requires a review of the basic principles, as we see them, of ILS investing. In our view, a good ILS investment has three general features.
The first feature is that ILS should relate to important risks. In this context, important typically means risks related to a highly concentrated economic activity, but it can also mean risks of national importance or of strategic importance to a corporation. In the field of insurance, highly concentrated economic activity is easiest to recognise by a dense concentration of housing and buildings and ILS typically cover regions with trillions of US dollars in building values located in relatively small areas. However, ILS can also cover things like national emergency aid entities or rail networks, even where they pass through sparsely populated areas, if they are strategically important to the issuer. This first feature gives the ILS a chance to offer good “reward”.
The second feature is that the ILS should have risks that are reasonably quantifiable. This should allow an ILS investor to set a reasonable upper bound on the estimate of risk to the security. Put together with the first feature, a good “risk-reward” might be achieved. Whether a risk is “modellable” is often misunderstood. For example, some will say that the risk of natural catastrophes can be modelled, but so-called man-made risks cannot. We do not believe this is true. The misconception likely arises from the notion that complex market risks can be difficult to model. This, we acknowledge, is true, but the catalogue of quantifiable man-made risks is large. The main problem is that they are often not well compensated for in the market. In practice, “modellability” is a function of how much forgiveness is allowed, i.e. what degree of uncertainty is acceptable in the modelling. When a risk is not well compensated, the risk estimate often needs to be more perfect than is practical to achieve. When a risk is extremely well compensated, an intelligent non-specialist is able to set a reasonable upper bound on the risk and find it adequate to drive a rational decision to invest.
The third feature of a good ILS investment is that it should not be a plain vanilla market investment in disguise. Some call this last feature non-correlation, which is a hallmark of alternative investments, but the term as it pertains to ILS is often misunderstood and misapplied. Put simply, ILS non-correlation should mean a crash in the stock markets will not cause an ILS investment to lose principal. It would be incorrect, however, to say that the alternatives investment thesis is possibly violated because, for example, a large enough earthquake might cause a loss to both an ILS investment and a temporary drop in a stock market index. The earthquake risk is already borne by a stock market investor with no compensation. By shifting a unit of exposure from the stock market to an earthquake ILS, an investor is moving from an uncompensated to a compensated component of risk. That has immense benefit to portfolio-level risk-reward, similar to that achieved through classic diversification. By explicitly targeting risks therefore investors stand a chance of being adequately compensated for them in the context of an ILS.
So where does the market go from here? At ILS conferences we often hear people asking whether we will see more terrorism risk bonds, or even cyber risk bonds. We do not know where the market will go, but we believe that exotic perils will, in general, remain a minor part of the ILS market in the near term – at least in terms of notional risk exposure outstanding. Again, this comes back to the observation that natural catastrophe risk is so much bigger than exotic ILS risks. In the case of terrorism bonds, the question is not whether or not the traditional reinsurance market is getting “full on the risk”. The traditional reinsurance markets seem to have the risk well in hand, both from a risk capacity and a modelling point of view.
However, as people and productivity continue to progress, both physically and virtually, new risks will increasingly emerge – perhaps even some with the potential to create insured losses that equal or exceed the current risks to property from natural perils. In the long run therefore, in the decade and more ahead, as demand for risk capacity begins to exceed the available reinsurance supply, what we currently call ILS exotic risks may not be so exotic after all. All the more reason, we believe, for us to pay attention to these investment opportunities as they emerge today.
Author: John Seo, manager of GAM ILS strategies. To find out more about GAM talk to your financial adviser.