Corporate ART may be about to come of age

Senior management of firms based in the Asia-Pacific region are waking up to the potential benefits offered by more strategic risk transfer buying. The region’s growing risk and insurance management community will reap the benefits if it provides its bosses with the right advice, particularly as companies expand to new market’s in new territories. Members of the Pan-Asia Risk and Insurance Management Association would therefore be well advised to take a close look at the emerging alternative risk transfer market as they prepare to impress their bosses with the range of options on offer. This is because there is arguably a confluence of classic demand-and-supply trends occurring currently in the global risk finance market that should deliver risk managers the world over with some interesting new options, and faster than many think. The demand factor comes from the risk management community and the corporations that they represent. The simple fact is that corporate risk managers are struggling to find the kind of comprehensive solutions that they need to tackle tricky emerging risks such as cyber, quickly enough from their traditional risk transfer partners.hideThe supply factor is based on the fact that the traditional risk transfer market is under pressure from the influx of new capital from the capital markets in search of returns. Record levels of reinsurance capacity, driven by the rise of the insurance-linked securities (ILS) market, is putting pressure on traditional reinsurers and insurers to deliver adequate returns in persistently soft traditional markets. One route to find growth and new profit is to enter emerging markets, such as Southeast Asia. But, as reported in Commercial Risk Asia, these markets are already saturated with capacity and stubbornly soft, partly because everyone has the same idea. Demand for cyber solutions Surely therefore, the answer is to come up with new solutions and ways of putting that risk capital to work in the emerging lines of business in which demand is so high, such as cyber. Up until now, this has looked good in theory but not so good in practice. In order to develop alternative risk-financing options such as catastrophe bonds, the capital markets need solid and easily available data, widely acceptable triggers and mutually agreed contracts. In the absence of these qualities, any deal simply becomes way too expensive to structure because the risk itself is too high and the frictional cost of constructing the actual deal impossible to justify. But signs are beginning to emerge that this market could be about to potentially come of age and be applied to risks other than relatively simple weather derivatives that were originally championed more than 20 years ago. Consider some headlines seen during the past couple of months. Aon last month announced that alternative reinsurance capital had grown by 12% last year, to reach $72bn. Supply is healthy and desperately in search of opportunities. Catastrophe modeling firm RMS revealed that it was ready to market a so-called ‘cat-in-a-box’ and parametric contract pricing app. The US-based Insurance Services Office said that it plans to collect terror event data to help develop terrorism ILS solutions. The modeling firms are also beginning to market models to help with analysis of famously tricky business interruption exposures. The models are therefore beginning to emerge and they are being applied to non-traditional risks. The World Bank last month announced that it plans to up its involvement in the emerging sovereign disaster risk transfer market a month after revealing that it had backed an index insurance scheme to help Kenyan farmers. The options are being broadened and the political will to try and put this excess capital to work in socially and economically useful ways is high. That can only help. Then at the end of April, US-based bank BNY Mellon announced that it believes that the London ILS market is perfectly positioned to become the global centre for cyber risk insurance. This announcement is worth considering in more detail. Karin Mulvihill, head of technology compliance at BNY Mellon, says: “The ability of cyber terrorists to target national infrastructure, power grids and other critical assets is a real and growing threat. This threat pervades businesses of all sizes and across all sectors.” Building blocks put in place The report states that it is early days yet but that the building blocks are starting to be put in place. “Although steps have been taken to standardise cyber risk data and to design products that cater for cyber terrorism, the insurance market for physical damage and bodily injury arising from a cyber-attack is nascent,” it states. But Paul Traynor, pensions and insurance segments leader, international, BNY Mellon, says the capital markets exist to help tackle such challenges. “The capital markets can help nascent classes of insurance flourish. There’s huge potential for cyber risk to be transferred to the capital markets using ILS, in a similar way to how cat bonds underwrite hurricane and earthquake risks,” says Mr Traynor. “However, before cyber risks can be successfully securitised, significant progress is needed in aggregating and modelling the risk. This requires more collaboration between major insurers and technology experts to better understand the interdependencies between systems and the frequency of attacks,” he continues. BNY Mellon’s report recommends new laws that would allow the incorporation of special purpose vehicles onshore within the London market to offer ILS sponsors and investors more choice and potentially allow new and emerging risks to be transferred to the capital markets. The main representative bodies of the London market have been working hard to persuade the UK government that this is a good idea during the past year or so. The government recently announced that it is seriously considering the proposals and rules that would allow the development of an ILS market in London. Other European insurance centres such as Malta and Guernsey are also keen to attract ILS and reinsurance special purpose vehicles to their markets and have come up with new laws to make this possible. Some markets are more ripe for such alternative risk finance solutions than others. Sectors that are vulnerable to extreme weather are perhaps best placed to enter this market. One risk manager for a Swiss-based global airport service company told Commercial Risk Asia’s sister paper Commercial Risk Europe last year that he was very interested in talking to the capital markets about a solution that would kick in when weather becomes so harsh that airports are forced to close, probably on a parametric rather than traditional indemnity basis to protect cashflow rather than assets. International broker Willis Towers Watson believes that the energy market is ripe for primary alternative risk transfer (ART) solutions and has already seen examples of how it can work. The broker last month published its annual Energy Market Review 2016 and two of its leading ART experts—Claire Wilkinson, managing director of alternative risk transfer solutions and co-head of the global weather practice; and Julian Roberts, senior member of the broker’s alternative risk transfer solutions team—argue that this market is gaining traction. ART is nothing new The experts point out that the ART market is nothing new. Insurers and risk management professionals have been talking about it since the 1990s. The potential of this market was obvious back at the start. But towards the end of the 1990s it became rather tarnished. Accounting bodies decided that solutions such as ‘time and distance’ policies did not really constitute real risk transfer and thus amounted to little more than a tax dodge. Apparently cutting-edge reinsurers who claimed to represent the future of the industry such as Centre Re came… and went. This reporter for one found himself increasingly confused in interviews with ‘experts’ who talked of the power of securitisation to ‘amortise’ risk (make it disappear), such as buckets of sub-prime mortgage guarantees. Those insurers and reinsurers that dipped their toes into this potentially huge market rapidly made losses and pulled out. But ART survived this tricky period and, as explained by the experts at Willis Towers Watson in their recent report, offers some genuinely exciting risk transfer and management options for more forward thinking risk managers. As noted above, the arrival of lots of new capital into the reinsurance and insurance market has persuaded insurers to take another look at the ART market. “Insurers in both Europe and the US have responded with investments in ART-focused teams and a willingness to offer more flexible and bespoke, solutions to the risk issues of corporate buyers,” states the Willis Towers Watson report. But it is not just about capital, it is also about the rise of lots of new and improved data. “The far greater availability and sophistication of data creates opportunities for innovative (re)insurers to price and underwrite new types of risk business,” argue Ms Wilkinson and Mr Roberts. At the same time, the energy market is experiencing a period of transition that is driving demand. “Not only is the nature of both supply of and demand for energy changing, but also the environment in which those two drivers exist—not least the focus on carbon emissions, resilience from climate change and the wider adoption of renewables,” says Willis Towers Watson. “Today, the energy sector is confronting challenges from a variety of diverse influences, including global economic stagnation and a seemingly intractable weakness in the oil market,” continues the report. “At the same time, risk managers in the sector are increasingly confronting emerging risks that are traditionally difficult, or perceived as impossible, to insure. These include non-damage business interruption, environmental, climate, reputational and cyber risks, the impacts of which can amount to many billions of dollars of cost,” point out Ms Wilkinson and Mr Roberts. Integration of products The Willis Towers Watson team says the key to growth in this market is the ability to integrate traditional re/insurance products and capital market techniques with forms of self-funding, flexible multi-year, multi-line and multi-trigger products. “The ability to draw upon this broad palette is enhanced by the availability of deep pools of data that were previously unavailable or effectively so within reasonable time and cost constraints,” they add. An example of this is the arrival of open-source satellite-derived imagery that enables the pricing and settlement of contracts in real time. This was unimaginable only a short time ago. The evolution of the catastrophe bond and ILS market during the past 20 years is also helping drive supply into this new market according to the Willis Towers Watson experts. They argue that the appetite of the capital market investors has definitely broadened in terms of the type of underlying risk they are prepared to invest in and the forms in which these contracts are drawn. This latter point is important because experts have long argued that it will be impossible to apply capital market funds to catastrophe style bonds for individual corporates, no matter how big and diverse, because they need an indemnity contract that the capital markets just do not understand or have the long-term appetite to honour risks with long tails such as liability. But perhaps this is changing to the benefit of the risk and insurance manager. The Willis Towers Watson experts state in the report: “Notably, there is some willingness to accept traditional indemnity style (or ultimate net loss) contracts whose payouts are the same as traditional insurance or reinsurance contracts.” But, in the broker’s view, parametric, or index-based, contracts are still a more suitable basis for the efficient participation of alternative risk investors, particularly if looking to cover the risks of corporate buyers rather than reinsuring insurance company risks. This is because indices can be designed to suit any risk situation so long as there is data available upon which to structure and price the contract and upon which to settle claims. Bespoke coverages This means that buyers can develop bespoke coverages to reflect their own specific circumstances. The Willis Towers Watson team says there are a number of requirements for good index design and the underlying data. These are: The data must be independent. It needs to be measured and recorded by a third-party that is trusted by both buyer and seller; There can be no subjectivity or lack of transparency in the way in which the data points are measured or compiled; The data should not be subject to historic (or indeed future) discontinuities that cannot reasonably be accounted for; The index data must continue to be reported in the same way (and generally by the same agency) during the foreseeable duration of the contract; Correlation to actual underlying losses is essential. The Willis Towers Watson team explains that an index-based contract is only a good alternative to traditional indemnity style contracts if the index provides a good proxy for the actual underlying losses. For this to work, a strong correlation in statistics terms needs to be shown between the historic performance of the index and the losses sustained by the buyer. This may not occur if the measurements for the index data are taken at a time or place that does not accord well with the activity and location of the risks in question. Likewise, a simple single parameter index such as wind speed or rainfall may not be sufficient to capture all the components of risk that affect the insured assets or the revenues/costs of the buyer. The Willis Towers Watson team points out that it is possible to design highly complex multi-parameter indices that can fit the actual loss profile more accurately. But while such a complex index design may have scientific merit or mathematical credibility, it may be difficult to explain to buyer or seller. Basis risk critical So-called basis risk is critical to the design of any index-based contract. Basis risk has to be estimated and discussed between buyer and seller to ensure absolute transparency, points out the Willis Towers Watson team. But this potential for mismatch between actual loss and contract payout is not confined to parametric structures, it adds. “Conventional contracts of insurance and reinsurance also contain terms and conditions (exclusions, warranties, excesses, waiting periods and the like) which can severely constrain the payment obligations of the insurer,” states the Willis report. “Some would argue that these conditions of non-payment are far more penal and prone to subjective interpretation than the very simple operation of an index,” it adds. Speed and simplicity of contract settlement is another big factor, according to Mr Roberts and Ms Wilkinson. They argue that while basis risk is a potential disadvantage of contracts that respond to an index as opposed to the actual losses sustained by the buyer, the use of a parametric index provides functional and economic advantages over the more conventional indemnity-style contract. The most obvious of these is the speed and simplicity of contract settlement (payout or otherwise) after the event or at the end of the contract period. Rapid settlement The Willis experts point out that, so long as the underlying index data is available without delay, there is no reason why the settlement amount cannot be agreed immediately and payment made within a number of days. Two weeks would be a typical timeframe in which to reach such an agreement, they say. “This speed and simplicity of payment, especially after a severe event, can easily compensate for any differences that might be observed between an index-based contract and the conventional indemnity process which can, in the most complex cases, take months or even years to finalise,” states the report. “It is the case that alternative, including and especially index-based, contracts provide the potential for contractual risk transfer where simply none would otherwise be available from conventional insurance providers,” “Index-based solutions are not a replacement for traditional insurance, but can often provide solutions for risks where traditional insurance is either not available, non-responsive or only available at economically unfeasible cost,” adds the report. Examples of how such solutions could benefit risk and insurance managers in the energy sector, for example, would be the cost of evacuating offshore platforms in the event of real or forecast windstorm activity, the cost uncertainty associated with the construction and maintenance of offshore facilities in high wind or wave conditions, or the variability of power output from renewable energy plants that rely on the availability of wind, water and solar, states the Willis team. Mr Roberts and Ms Wilkinson conclude that, while index-based solutions are one form of ART, the term encompasses a much broader range of solutions. These solutions can be put to work to provide more efficient structuring for traditionally insurable risks, to access deeper pools of risk capital or to provide capacity for otherwise uninsurable exposures—such as supply chain vulnerability, cyber, pandemic and brand/reputational risk, they state. “ART solutions merge the best of capital market techniques with traditional insurance, risk-sharing and risk-retention structures, all underpinned by sophisticated analytics, to enable companies to select the most efficient form of risk financing for their specific risk profile, risk exposures, risk appetite and cost of capital,” argue the report authors. Captive solutions, portfolio solutions and structured solutions all form part of the ART “palette of options” that risk managers can consider to more efficiently manage their corporate risk. “ART is increasingly considered ‘mainstream’ among the more ‘risk management-savvy’ corporates and there is evidence of a positive correlation between a company’s general sophistication and the adoption of ART solutions as part of their overall risk management strategy,” conclude the Willis Towers Watson experts.

Corporate ART may be about to come of age

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