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ILS Market Update
November 2018
Index triggers: no panacea but still helpful
Definition and uses of index triggers
Index triggers are based less on actual loss than on a proxy for actual loss. Proxies
include industry loss indices based on PERILS or PCS figures, pure parametric or
parametric index triggers, modeled loss triggers or hybrids, or population mortality and
morbidity statistics.
As a technical matter, most “index triggers” are in reality implemented as double triggers
where a recovery only occurs if the index trigger is met and the cedant suffers actual
losses as well. In that case, they are in fact contracts of indemnity and generally treated
as reinsurance for legal and accounting purposes.
Pros and cons
Index triggers have various pros and cons. The primary advantages include enhanced
speed of calculation and recovery, transparency and ease of understanding for all parties.
These attributes can potentially save cedants money by accessing capital more efficiently.
The primary potential drawbacks are poor design and basis risk. If not thoughtfully
designed, index triggers can be more rather than less complex and slower rather than
faster to determine. In fact, a poorly designed trigger can even enhance rather than
mitigate dispute risk and make accurate modeling more rather than less difficult.
Practically speaking, basis risk means a mismatch between expected recoveries and
actual recoveries. It is not exclusive to index-triggered ILS deals. For example, the
application of an exclusion or an hours’ clause in a reinsurance contract based primarily
on actual losses can also result in a mismatch.
ILS Market Update
2
Q3 2018 market perspective: Index triggers: no panacea but still helpful
One constant in the ILS market going
back nearly 25 years is the steady
stream of cheerleaders claiming index-
triggered ILS can unlock massive
amounts of capacity, grow the
alternative capital market and close the
protection gap. Notwithstanding these
claims, the market has largely moved
away from rather than toward index
triggers and in our view, will likely
continue to do so. That being said, there
remain some excellent use cases for
index triggers.
“Most “index
triggers” are in
reality
implemented as
double triggers
where a
recovery only
occurs if the
index trigger is
met and the
cedant suffers
actual losses as
well.”
“The primary
potential
drawbacks are
poor design and
basis risk.”
Most risk managers and ceded reinsurance professionals care more about a shortfall in
expected recoveries than in the potential for an over-recovery. A shortfall can even risk
cedant insolvency. Basis risk can increase the required limit purchased for a given risk
management objective thereby nullifying the discounted spread otherwise available for
using an index. It is this trade-off between potential savings and basis risk that seems to
drive most decisions for or against index triggers. Unbiased advice from intermediaries is
very helpful here.
General trend away from index triggers
In practice, outside of retro, as the available premium or risk spread discount for index
triggers has declined relative to indemnity triggers, the share of index trigger transactions
has declined as evidenced by the market share trend illustrated below. Trends beyond the
cat bond market are similar. This is a good news story. It reflects improved data,
transparency, and understanding of indemnity risk rather than any inherent discomfort
with index triggers.
Some exceptions
Notwithstanding the general trends and issues raised above, index triggers remain
important in some special situations. First, index triggers remain common for retro,
whether for cat bonds or ILWs. Second, where the underlying data quality is poor or the
coverage is exceptionally difficult to model (e.g., business interruption for certain classes
of business), the discount for an index trigger can rise considerably making an index
trigger more attractive. Recent sovereign nat cat and extreme mortality ILS deals come to
mind. Another example is Japan, where earthquake derivatives are popular with large
corporates to hedge their risk.
Indemnity Index
ILS Market Update
3
Q3 2018 market perspective: Index triggers: no panacea but still helpful
“A shortfall can
even risk
cedant
insolvency.”
60%
40%
34%
66%
Year-end
non-life
capacity
outstanding
($ billions):
2008
$11.8
2018 YTD
$27.8
Evolving market share of indemnity and index triggers
“The available
premium or risk
spread discount
for index
triggers has
declined
relative to
indemnity
triggers.”
“Index triggers
remain
important in
some special
situations.”
Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018. Aggregate data excludes private ILS deals.
ILS Market Update
4
Q3 2018 market perspective: Index triggers: no panacea but still helpful
“Intermediaries
also
increasingly
design relatively
more refined
and
commoditized
index triggers
that both reduce
basis risk and
result in broad
syndication
achieving the
best price.”
Outlook
Some say that if index triggers drive down costs enough, they can reduce the protection
gap substantially, notwithstanding the resulting basis risk. Theoretically, this is possible.
The evidence thus far suggests a more limited benefit - as you have to deliver a product
people will actually buy. Yes, index triggers can help close the gap, but they will not be
transformative on their own. Wishful thinking cannot overcome math and economics.
On a more optimistic note, the ability to measure and manage basis risk continues to
improve. Intermediaries and other unbiased advisors work more and more with insureds
and cedants to understand the trade-offs inherent in index triggers and to manage basis
risk. Managing basis risk occurs, for example, through better overall design of a
reinsurance program explicitly taking basis risk for a single index protection into account.
Intermediaries also increasingly design relatively more refined and commoditized index
triggers that both reduce basis risk and result in broad syndication achieving the best
price. This design process prevents a handful of large self-interested reinsurers and ILS
managers from foisting bespoke triggers on unsuspecting buyers, in which customization
serves primarily to thwart competition and raise rates rather than to achieve any
meaningful advantage for buyers.
* * * * *
In sum, as the insurance, reinsurance and ILS markets work together to solve new
problems for insureds, index triggers are a very useful tool to consider. They may not on
their own close the protection gap, dramatically grow the ILS market, or solve all cedant
problems - far from it. Nevertheless, with creativity, unbiased advice and sustained effort,
they can still have a meaningful impact.
The third quarter of 2018 saw five underwritten widely distributed non-life ILS issues
totaling approximately $1.6 billion of capacity, surpassing Q3 2013’s record of
approximately $1.4 billion. This record-breaking Q3 issuance seems to put this year’s $8.7
billion year-to-date issuance (as of Q3-end) on track to approach or even exceed last
year’s record of $9.7 billion.
Of the roughly $1.6 billion issued this past quarter, $200 million will provide Peak Multiperil
protection and $650 million will provide U.S. Earthquake protection. The remainder will
cover new perils, with $500 million providing protection from Flood resulting from U.S.
Wind and $200 million providing California Wildfire Liability protection.
In Q3 2018, AXIS secured additional capacity through Northshore Re II. A key difference is
that unlike prior Northshore Re deals, it will also provide protection against European Wind
exposure in addition to the protection from U.S. Wind and U.S. Earthquake the prior deals
provided. The tranche features an industry index trigger on an annual aggregate basis. It is
also noteworthy that this tranche will feature a four-year term, up from three years in the
prior series. The issue has an expected loss of 4.86% with a risk spread of 7.70% that fell
below its initial guidance of 8.00% to 8.50%. The bond was upsized 33% from an initial
guidance of $150 million to $200 million.
Kaiser Permanente returned to the cat bond market as a repeat corporate sponsor to
access additional capacity through Acorn Re as its 2015 series neared maturity. This
tranche provides per occurrence protection from North American Earthquakes with a
parametric trigger. Earthquake box locations lie along the West Coast of the U.S. and
extend into parts of Sonora Mexico, British Columbia and the Pacific Ocean. The trigger
has four levels based on severity of magnitude. Northern California contributes to more
than 80% of the initial modeled expected loss of 0.80% (compared to an initial modeled
expected loss of 0.74% for the 2015 series). The deal was initially marketed with a
guidance of $300 million (the same size as the matured 2015 series) and upsized 33% to
$400 million. This tranche priced with a risk spread of 2.75%, which is lower than the
3.40% for the 2015 series.
Following substantial loses from 2017 named storm events, the National Flood Insurance
Program (NFIP) added to its relatively new private reinsurance program with its first cat
bond capacity via two tranches of notes issued through FloodSmart Re. The NFIP is a
federal government-operated flood insurance program administered by the U.S. Federal
Emergency Management Agency that was formed to sustain the availability of voluntary
flood insurance. Historically, funding shortfalls that exceed premiums collected have been
financed by the U.S. Treasury. In addition to featuring a first time sponsor, this transaction
marks the first known cat bond issuance using KatRisk as modeling agent. KatRisk
specializes in modeling flood and wind risk in the U.S. and Caribbean. The notes feature a
three-year term providing indemnity protection on a per-occurrence basis. Both tranches
upsized and priced at the bottom of initial guidance with the $325 million Class A tranche
paying a risk spread of 11.25%, while the $175 million Class B tranche will pay 13.50%.
ILS Market Update
5
Q3 2018 ILS market issuance overview
“This record-
breaking Q3
issuance seems
to put this
year’s $8.7
billion year-to-
date issuance
on track to
approach or
even exceed
last year’s
record of $9.7
billion.”
“The National
Flood Insurance
Program added
to its relatively
new private
reinsurance
program with its
first cat bond
capacity.”
“Kaiser
Permanente
returned to the
cat bond market
as a repeat
corporate
sponsor to
access
additional
capacity
through Acorn
Re.”
Non-life Q3 2018 ILS issuance(a)
Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018. Aggregate data exclude most private ILS deals.
(a) All issuance amounts reported in or converted to USD on date of issuance. EL for HU deals is based on WSST conditioned catalog for AIR and medium-term catalog for RMS
(b) If fronted, beneficiary listed if known
ILS Market Update
6
Q3 2018 ILS market issuance overview
Q3 2018 also featured a first time corporate sponsor, Pacific Gas and Electric (PG&E),
bringing a new peril to the cat bond market through Cal Phoenix Re. PG&E is a U.S.
natural gas and electric energy company that provides service in Northern and Central
California. Cal Phoenix Re will provide California Wildfire Liability protection for losses
caused by power, transmission or distribution systems owned or operated by PG&E. This
deal will feature a three-year term with an indemnity trigger on an annual aggregate basis
and has embedded call options. With a modeled loss of 1.01%, the single tranche will pay
a risk spread of 7.50%. It is worth noting that the 2017 Thomas Fire would have resulted
in a total loss for this tranche.
The California Earthquake Authority effectively renewed its Ursa Re 2015-1 B issue that
matured on September 15, 2018, through Ursa Re 2018-1 D. The single $250 million
layer will provide about three years of indemnity protection on an annual aggregate basis
from California Earthquakes. The new deal features a 2.87% expected loss (modeled by
EQECAT) and will pay a risk spread of 5.10% after being marketing with a range of
5.00% to 5.25%.
“Q3 2018 also
featured a first
time corporate
sponsor, Pacific
Gas and
Electric,
bringing a new
peril to the cat
bond market.”
($ in millions)
Sponsor(b) Issuer/Tranche Issue Maturity Amount EL Spread Basis Risk Trigger
CEA Ursa Re 2018-1 D Sep-18 Sep-21 $250 2.87% 5.10% Annual AGG U.S. Quake Indemnity
PG&E Cal Phoenix Re 2018-1 A Aug-18 Aug-21 200 1.01% 7.50% Annual AGG California Wildfire Liability Indemnity
NFIP FloodSmart Re 2018-1 A Jul-18 Aug-21 325 4.94% 11.25% OCC U.S. Wind Indemnity
NFIP FloodSmart Re 2018-1 B Jul-18 Aug-21 175 6.32% 13.50% OCC U.S. Wind Indemnity
Kaiser Permanente Acorn Re 2018-1 A Jul-18 Nov-21 400 0.81% 2.75% OCC U.S. Quake Parametric
AXIS Northshore Re II 2018-1 A Jul-18 Jul-22 200 4.86% 7.70% Annual AGG Peak Multiperil Industry Index
Q3'18 Total: $1,550
ILS Market Update
7
Interview: Matthew Ball – Senior Director Insurance Consulting
Technology and Global ILS Consulting practice
“The loss
activity over the
last couple of
years has
certainly
presented some
challenges and
opportunities…
Valuation of
illiquid (level 3)
assets has
been one of the
challenges.”
Matthew Ball – Senior Director
Insurance Consulting Technology and
Global ILS Consulting practice
at Willis Towers Watson
How did you first get involved in the ILS space?
Before coming to Bermuda in 2010, I worked in the
London office for a number of years in the insurance
actuarial consulting practice of one of the
predecessor firms of Willis Towers Watson. It was
there during the mid-2000s that I first got involved in
a few alternative risk transfer projects, as the space
was called at the time. These involved securitization
of some pretty esoteric asset classes – venture
debt, pharmaceutical research and development
and carbon credits – where the structure included
both insurance and capital markets solutions. These
were challenging but very interesting projects.
There was no standard actuarial playbook in terms
of modeling these risks – and certainly no standard
vendor model – so you had to go back to first
principles.
After coming to Bermuda in 2010, to lead the Insurance Consulting and Technology (ICT)
practice here, I naturally got involved in more “traditional” ILS projects given Bermuda’s
leading position as a reinsurance and ILS market, working for various stakeholders (ILS
funds, sidecars, end investors, cedants and cat bonds) across various areas (valuation,
governance reviews, pricing and portfolio management and software solutions). This
involvement has grown over time, together with the growth in the ILS market, and a
number of years ago I led the formation of the ILS Consulting practice within ICT to tailor
our products and services to the needs of the ILS industry.
What sort of work do you do with ILS investors (besides in cat bond transactions)?
Has the loss activity the last few years presented any unique challenges or
opportunities? How do you see things changing in light of what has transpired?
Our ILS Consulting practice within ICT works with ILS funds and end investors providing
advice, solutions and software to help clients manage risk and capital, improve business
performance and create competitive advantage across a wide variety of situations
including independent third-party valuation, pricing, financial modeling and operational
due diligence reviews.
The loss activity over the last couple of years has certainly presented some challenges
and opportunities. We touched on a few of these aspects at a presentation we gave at the
recent ILS Convergence conference in Bermuda earlier in October of this year.
Valuation of illiquid (level 3) assets has been one of the challenges. Alternative
reinsurance capital has grown from $23 billion at the end of 2011, the last year of
significant loss activity before 2017, to $88 billion at the end of 2017; private ILS, such as
“collateralized reinsurance”, has been a key driver of this growth. So valuation of these
assets has become more important from an overall market perspective.
ILS Market Update
8
Interview: Matthew Ball – Senior Director Insurance Consulting
Technology and Global ILS Consulting practice
“The 2017
events were a
reminder that
valuation
techniques
need to adapt to
the context.”
“Currently, only
a third of ILS
funds are using
independent
third-party
valuation for
illiquid (level 3)
assets.”
“Good
governance and
transparency
are grease for
the wheels of
operations
within the ILS
industry and will
ultimately assist
with faster
growth.”
Given that ILS funds usually report NAVs on a monthly or more frequent basis, there can
be estimation challenges early on after loss events. This was illustrated in the aftermath of
Hurricane Maria, where there were estimates from two of the property cat model vendors
with non-overlapping ranges. When cedant estimates started to come in, some initial
cedant estimates were closer to the ultimate estimate than others. There is nothing
particularly new in some of these issues. The 2017 events were a reminder that valuation
techniques need to adapt to the context, for example, the type of event (e.g., hurricane,
wildfire, earthquake), time after the event (e.g., use of exposure methods, claims
development methods or a blend), local legal and claims environment (e.g., assignment of
benefits and demand surge in Florida post-Irma) and cedant valuation philosophy.
Overall, we continue to see valuation practices improve over time. It is better than the
“Wild West” we observed a few years back, but there is still work to do on improving some
of the technical aspects (e.g., valuation of losses close to attachments points or
aggregate excess of loss contracts), the operational efficiency of internal valuation
processes post-event and governance and overall transparency. Currently, only a third of
ILS funds are using independent third-party valuation for illiquid (level 3) assets (per Willis
Towers Watson’s recent ILS survey), although we have seen this demand increasing. In
addition, we have seen a growing demand from ILS funds for our valuation technology
and software solutions to improve operational efficiency. After the events of 2017, and
with a growing desire for more transparency in the industry, we anticipate the governance
demands from internal and external stakeholders will continue to increase. Funds that can
demonstrate a more robust, transparent and efficient valuation process than their peers,
all else being equal, should be able to assume more market share over time.
Trapped collateral and liquidity have also proved challenging to market participants over
the last couple of years. Despite the events of 2017 and the material amounts of trapped
collateral, the market still managed to more than reload on January 1, 2018. Nonetheless,
we did see an increase in questions from our clients around trapped collateral; for
example: how much collateral was trapped and for how long? Should we move from more
of a direct model to a fronting model? How can we improve the collateral release
mechanisms? So the opportunity here is for the funds that can manage their collateral
more efficiently and potentially a broader market opportunity to allocate capital to
collateral release solutions. Also, there seems to be a general market desire to try to
improve some of the underlying collateral release mechanism structures.
If you could change one thing about the ILS market, what would it be and why?
One particular area we focus on is helping clients improve the governance and
transparency of their operations; for example, the loss reserve specialist and claims
reviewer roles performed for cat bonds, or the third-party independent valuation agent
roles performed for ILS funds, sidecars and end investors. The Standards Board for
Alternative Investments is also pushing for greater transparency in the ILS space. Overall,
the industry has progressed in recent years in terms of governance and transparency, yet
there is still work to be done as discussed above. I would like to see this progress quicker.
Good governance and transparency are grease for the wheels of operations within the
ILS industry and will ultimately assist with faster growth as more and more investors
become attracted to the ILS space.
ILS Market Update
9
Q3 2018 ILS market statistics
Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018. Aggregate data excludes private ILS deals.
(c) All issuance amounts reported in or converted to USD on date of issuance. Outstanding amounts adjusted for actual principal losses.
Par outstanding by expected loss at issuance Par outstanding by risk peril
Total: $25.5 billion(b)Total: $27.8 billion(a) Total: $25.5 billionTotal: $27.8 billion
Peak Multiperil U.S. Wind U.S. Quake
Euro Wind
Japan Quake
Japan Wind Others Non-Life 2.51% – 4.50%
<0.75% 0.76% – 1.50% 1.51% – 2.50%
>4.51%
Non-life ILS issuance by quarter (2014 – 2018)(c)
($ in billions)
Non-life capacity issued and outstanding by year(c)
Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018.
(a) In aggregate, 66% of all capacity outstanding exposed to U.S. Wind.
(b) In aggregate, 66% of all capacity outstanding exposed to U.S. Wind.
($ in billions)
Issu
ed
cap
acit
y/
cap
acit
y o
uts
tan
din
g Nu
mb
er o
f deals
55%52%
11%14%12%
16%
8% 8% 3% 1% <1%
4%
11% 5%
0%
10%
20%
30%
40%
50%
60%
Q3'18 Q3'17
13%16%
28% 28%21% 22%22% 22%
15% 12%
0%
10%
20%
30%
40%
50%
60%
Q3'18 Q3'17
$1.2
$4.5
$0.3
$2.1$1.5
$2.7
$0.7
$1.4$2.0
$1.0 $0.9
$2.1$1.7
$6.2
$0.5
$1.3
$3.1
$4.0
$1.6
0.0
1.5
3.0
4.5
6.0
$7.5
Q1 Q2 Q3 Q4
2014 2015 2016 2017 2018
$4.6
$7.2
$2.7 $3.4$4.8 $4.3
$5.9$7.1 $8.0
$6.2 $6.1
$9.7 $8.7$8.4
$14.1$11.8 $12.3 $12.4 $12.7
$15.2
$18.7
$22.9 $22.5 $22.8
$25.5$27.8
0
5
10
15
20
25
30
0
5
10
15
20
25
$30
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018YTD
Issued capacity Outstanding at year-end # of deals
6.3% 6.3% 5.6%
6.1% 5.9% 5.9% 6.2% 6.3%
7.5% 7.6% 7.3%
6.4%
5.5% 5.4% 6.0% 6.1% 6.1%
6.4%
2.3% 2.3% 2.0%
2.4% 2.5% 2.5% 2.8% 2.8%
3.8% 3.9% 3.9% 3.4%
2.8% 2.7% 3.1% 3.0% 3.1% 3.2%
0.0%
3.0%
6.0%
9.0%
0.0%
3.0%
6.0%
9.0%
Q2'14 Q3'14 Q4'14 Q1'15 Q2'15 Q3'15 Q4'15 Q1'16 Q2'16 Q3'16 Q4'16 Q1'17 Q2'17 Q3'17 Q4'17 Q1'18 Q2'18 Q3'18
Secondary market trading overview
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ILS Market Update
10
Q3 2018 ILS market statistics
Source: Willis Towers Watson Securities Transaction Database as of 09/30/2018. Aggregate data excludes private ILS deals.
LTM = Last 12 months. Aggregate data are for primary issuance and do not reflect secondary trading.
Q3 2018 saw very light secondary trading. There were intermittent lists of bonds being
moved in small size, with very few meaningfully sized trades. Investors lamented the
Irma creep, and it is interesting to note that the traditional cat bond bounce for seasonality
was relatively muted. We anticipate traders will look optimistically towards the new
primary issuances in Q4, which will ultimately help the secondary market settle into
appropriate trading ranges.
Weighted average risk premium Weighted average expected loss
“Investors
lamented the
Irma creep, and
it is interesting
to note the
traditional cat
bond bounce
for seasonality
was relatively
muted. ”
Quarterly LTM non-U.S. Wind exposed weighted average risk premium and expected loss
Quarterly LTM U.S. Wind exposed weighted average risk premium and expected loss
2.7% 2.6%
3.4% 3.3% 3.5% 3.7%
2.9% 3.1% 3.4%
2.8%
3.7% 3.8% 3.9%
4.5% 4.3%
3.7% 3.5% 3.6%
0.8% 0.7%
1.3% 1.3% 1.3% 1.5%
0.9% 1.0% 1.0% 0.7%
1.3% 1.4% 1.8%
2.4% 2.4% 2.0% 1.9%
1.7%
0.0%
2.0%
4.0%
6.0%
0.0%
2.0%
4.0%
6.0%
Q2'14 Q3'14 Q4'14 Q1'15 Q2'15 Q3'15 Q4'15 Q1'16 Q2'16 Q3'16 Q4'16 Q1'17 Q2'17 Q3'17 Q4'17 Q1'18 Q2'18 Q3'18
Howard Bruch
Managing Director and Head of Sales and Trading
+1 212 915 8407
William Dubinsky
Managing Director and Head of ILS
+1 212 915 7770
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