Tag Archives: Aaron Koch

Can non-NatCat insurance-linked securities diversify risk?

A developing insurance-linked securities (ILS) market trend has resulted from the rise in non-life ILS that transfer risks outside of the natural catastrophe space. However, no particular type of “non-NatCat” deal has achieved the same widespread acceptance as NatCat deals. While non-NatCat innovation could open up enormous avenues for market expansion, flawed transactions leading to losses could give investors reason to question the stability and growth potential of the market.

These issues are complex, requiring creativity and coordination across the key participants on a non-NatCat transaction. This paper by Aaron Koch explains non-NatCat ILS. He also explores the potential types of non-NatCat transactions.

Will Hurricane Matthew adversely affect the ILS market?

Hurricane Matthew was the most significant windstorm to affect the United States since Sandy in 2012. It is estimated to result in $4 billion to $7 billion in property insurance losses. In this article, Milliman actuary Aaron Koch considers the effect that Matthew may have on the insurance-linked securities (ILS) market and alternative capital investors. He also offers perspective on whether the storm will have any influence on U.S. property catastrophe reinsurance rates, which have decreased in the last several years.

Here is an excerpt from the article:

Based on the impact profile of Matthew, we expect two sets of loss impacts to ILS fund valuations based on the storm:

1. Minor realized losses on collateralized reinsurance per-occurrence layers and sidecars

We might expect a minor to moderate amount of losses on the lowest layers of collateralized reinsurance programs. Key driving factors to consider include the proportion of economic loss that ends up being excluded by residential policies given the flood-heavy nature of the storm; a fund’s exposure to Florida-only writers versus those that are diversified across the Southeast (and thus potentially exposed to a larger proportion of the storm’s impact); and any limits that are written in the Caribbean, which suffered direct landfalls from Matthew across several countries, including Haiti and the Bahamas.

2. Minor writedowns on collateralized reinsurance aggregate layers and aggregate ILS deals

We expect that Matthew’s broader impact might be across the set of deals where Matthew will contribute towards an overall aggregated retention. Even if Matthew is not itself strong enough to trigger a loss to certain catastrophe bonds, ILWs, and collateralized reinsurance contracts with aggregates, we do expect that it will often exceed these contracts’ deductibles (in either standard or franchise form) to accrue a portion of the loss needed to erode the aggregate retention.

In these cases, the erosion of part of the aggregate retention makes the contract more susceptible to suffering loss over the remainder of the contract period (i.e., if future major loss events were to occur). As a result, the valuation of these contracts should see a slight negative impact from Matthew.

Fortunately, Matthew comes relatively late in the hurricane season. Thus – with the exception of multiple-year contracts – there is a correspondingly lower chance of additional U.S. wind events pushing the loss above the aggregate retention. As such, we can expect Matthew’s negative impacts on fair value estimates to be relatively small and to reverse quickly back up to full value assuming that no further events occur this year.

Complex nature of private ILS valuation

The valuation of private collateralized reinsurance deals in insurance-linked securities (ILS) funds is complex because of their customizable features. An actuarial reserve analysis is essential to create an appropriate valuation for these types of reinsurance transactions. A recent Artemis article, based on a paper written by Milliman actuary Aaron Koch, highlights the challenge involved with this process.

Here is an excerpt:

“This expansion of collateralised reinsurance and other private risk-taking structures (such as Lloyd’s syndicates and fund-sponsored reinsurers) enables funds to underwrite a much broader range of risks and access higher returns, but it also poses a set of new challenges,” explains Koch, in a white paper within a recent publication by Clear Path Analysis …

…Koch explains, “One such challenge is the valuation of these generally illiquid instruments.”

Unlike traditional 144A catastrophe bonds the large majority of private ILS contracts and ventures don’t have a secondary trading element and are far less liquid.

As a result of this Koch explains that for most private ILS transactions there is no suitable “mark-to-market” price that reflects risk seasonality, meaning that funds that wish to value private reinsurance business consistently with mark-to-market instruments (such as 144A catastrophe bonds) need to create a “mark-to-model” valuation approach that incorporates elements such as risk seasonality into the valuation.

While in theory this might sound simple enough, Koch notes that in reality, some private ILS deals have complexities such as covering multiple perils and regions across both property and specialty lines, as seen with traditional reinsurance contracts.

The above, combined with the potential inclusion of un-modelled risks, “requires substantial modelling resources,” says Koch, that perhaps certain ILS investors may lack when compared with traditional reinsurers.

To read the entire Artemis article, click here.

Measuring the impact of “locked collateral” on collateralized reinsurance returns

Collateralized reinsurance has become an essential tool for catastrophe-focused investment managers (insurance-linked securities managers). These private, customizable deals can provide exclusive investment opportunities. But they also require specialized underwriting expertise and a network of relationships not every insurance-linked securities manager possesses. Milliman consultant Aaron Koch provides some perspective in this article.

The evolving insurance-linked securities market

In a recent Captive.com interview, Milliman consultant Aaron Koch discusses the effects that insurance-linked securities (ILS) have had on captives and the reinsurance market. He also provides some perspective on the prospects of the ILS landscape. Here is an excerpt from the article:

Captive.com: What has the impact of ILS been on the traditional reinsurance markets that captive owners are familiar with?

Mr. Koch: There have been at least three major impacts: reductions in prices, loosening of terms and conditions, and an increase in reinsurance mergers and acquisitions (M&A) activity.

ILS provides a product that competes with traditional reinsurance. The increased supply of risk-taking capacity has led to reductions in the price of coverage, particularly on property catastrophe business. Alternatively, some contracts have seen their terms and conditions changed in a way that benefits the cedent, often by including more risk or by otherwise making it more likely for the contract to pay out (e.g., by extending the “hours clause,” which defines the length of a catastrophe event).

The increased competition in the market has also helped drive a wave of M&A activity, as reinsurers seek to gain economies of scale and diversify their writings away from the property catastrophe market.

Captive.com: Two follow-up questions: (1) What do you see as the market impact of ILS in the next 3–5 years? (2) Do you see the ILS market evolving to cover other risks?
Mr. Koch: The ILS market is at an interesting crossroads. In my opinion, the first wave of ILS growth has largely passed. The traditional sources of risk—primarily large insurance and reinsurance companies—seem comfortable with the amount of ILS they currently buy. The market has reached somewhat of a steady state among these participants.

However, there is still a huge amount of investment capital looking to enter the market. As a result, ILS is poised to grow over the next 3 to 5 years through product innovation. There are two major vectors for this growth. One is market expansion to cover different types of insurance risk. Examples include the recent rise in specialty insurance transactions and the ongoing efforts to bring liability risk to the ILS market.

Perhaps more interesting to captive owners, however, is a recent trend toward expanding the ILS market to a more diverse range of cedents. The ILS market’s willingness to invest in smaller, more customized transactions is high. This provides opportunities for cedents that do not have enough scale to sponsor a full-sized catastrophe bond to still purchase coverage. Investors have been willing to sponsor innovative transactions to accommodate the needs of new cedents—and this is something where captives will likely take advantage.

Diversifying catastrophe risk through collateralized risk obligations

Insurers generally limit their exposure to catastrophe risk, often by purchasing expensive reinsurance coverage. Introducing a new product based on a collateralized debt obligation (CDO) structure may help insurers diversify a significant portion of catastrophe risk by pooling the risk among a large number of financial investors. In his article “A new model for weathering risk: CDOs for natural catastrophes,” Milliman’s Aaron Koch provides some perspective on the potential benefits of these collateralized risk obligations (CROs), and how they compare to existing uses of the CDO structure.

CDOs generate new investment opportunities because the most senior CDO tranches typically receive credit ratings far in excess of the ratings of the underlying collateral. These high ratings proved to be illusory for the pre-crisis market of subprime mortgage-backed CDOs. An appropriately designed CRO would be significantly more robust than these pre-crisis CDOs for three reasons.

First, a sufficiently diversified portfolio of catastrophe risk does not suffer from the same systemic vulnerabilities that affected the mortgage markets. Unlike housing markets—which are affected by the state of the economy—there is no single “macro factor” that is responsible for all natural catastrophes. Instead, well-designed CROs would enjoy geographic diversification: For instance, Asian typhoon activity is not fully correlated (and, in fact, may be inversely correlated) with North American hurricane activity. A catastrophe risk pool may also benefit from typological diversification. Natural disasters can be geophysical (e.g., earthquake), meteorological (e.g., convective storms and tropical cyclones), or even climatological (e.g., drought) in nature. Each type is driven by forces that are not fully correlated—and often may not be correlated at all. For example, the occurrence of a Japanese earthquake is unlikely to impact the likelihood of a major U.S. hurricane.

Second, the modeling process for a CRO should be more robust and transparent than that for pre-crisis CDOs. Pre-crisis CDOs often contained pieces of thousands of individual mortgages, requiring major simplifying assumptions to make the pricing model tractable. Often, reliance was placed on some form of the normal distribution and a single, catch-all assumption of constant correlation across the entire structure. ILS such as catastrophe bonds are significantly larger than individual mortgages, and relatively fewer are required to create a financially viable pool. In conjunction with the existing structural risk models for natural catastrophes, this allows for more nuanced pricing techniques to represent the asset interdependencies within the pool.

Third, incentives for CRO cedents are aligned with the incentives of the CRO investor. In the subprime boom, mortgage originators and CDO underwriters were paid based on volume and often retained none of the ultimate risk, giving them every incentive to prioritize quantity over quality when structuring CDOs. In contrast, the “originators” of catastrophe risk are insurers, who retain the first-dollar exposure on their policies (and often a pro rata share of the excess reinsured catastrophe loss). This retention of risk should serve to align the interests of market participants in a way that was never present in the pre-crisis CDO market.