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First Five Steps to Making Exchange-Traded Risk a Reality

December 8, 2015 by Tom Johansmeyer

Too often, we focus on the end result. We want to see an idea through to its natural conclusion, and we’re excited by the possibilities that—so far—exist only in our minds. It’s no secret to anyone in the innovation-dependent reinsurance and insurance-linked securities (ILS) markets that there’s plenty of distance between potential and reality. And the decisions you make along the way ultimately will lead to success or failure. I’ve been thinking a lot about exchange-traded risk lately, and it clearly follows this pattern.

A binary option is a type of option in which the payoff can take only two possible outcomes, either some fixed monetary amount (or a precise predefined quantity or units of some asset) or nothing at all. Options linked to catastrophes can be described as binary because there is no payout when the subject catastrophe occurs.
For decades, our industry intuitively has understood the benefits that could come from trading listed binary catastrophe options, particularly real-time risk management and the opportunity to trade out of positions that otherwise would require issuance. But making a solution stick has been difficult. Since the beginning of summer this year, I’ve spoken to many in the market about how to make exchange-traded risk a reality, and from those conversations, I’ve taken five important lessons that need to become the guiding principles of any such effort.

1. Original risk: Every transaction needs a party with a need to hedge—and thus a reason to pay the option premium the capital provider would like to collect. Although a speculator could play the cedent role in limited instances, there really is no substitute for a pipeline of transactions from parties with insurable interest and a willingness to pay for protection. Original risk represents the cedent side of the equation—the risk that’s transferred to complete a step in the global risk and capital supply chain.

2. Relevant ancestry: Previous attempts at exchange-traded risk lacked the right lineage. They all seem to have been efforts to improve even earlier attempts at exchange-traded risk. And while the evolution of this concept does show increasingly savvy thinking with each iteration, the starting point at which they improve isn’t necessarily the most effective. The cat bond-lite market—rather than previous exchange-traded risk platform efforts—should be our new source idea.

Cat bond-lite represents a streamlined approach to securitized insurance risk transfer. More cost effective and faster to implement than a traditional catastrophe bond, cat bond-lite usually involves the securitization of an underlying industry loss warranty (ILW) or collateralized reinsurance contract. The goal of this approach is to provide increased liquidity and address the needs of ILS funds with mandates to invest in liquid instruments.

Through the past two years, the cat bond-lite market has shown us that original risk can come from a fund rather than a traditional insurer or reinsurer. Most cat bond-lite activity to date has been through fund-to-fund transactions, although some traditional reinsurers have begun to participate recently. Fund-to-fund may be a small market, but it could be that early step toward something much larger.

3. Independent advantage: An exchange-traded risk environment needs to offer benefits to cedents that are independent of the advantages of a mature, robust, liquid market. Reduced frictional costs and transaction time, for example, would attract market participants initially—and keep them engaged. As the market proves itself in its early stages, it will make progress toward earning the critical mass needed for self-sustaining liquidity.

4. Helping hand: To view exchange-traded risk as an attempt at disintermediation is to ensure that it never gets the initial momentum it needs. While a highly liquid market may be able to function without the help of reinsurance brokers, the odds of exchange-traded risk ever becoming highly liquid without their direct engagement are low.

Exchange-traded risk should be seen as yet another important tool in the risk and capital management toolbox—a more efficient version of the industry loss warranty. And while some types of transactions could be executed without facilitation, the majority of the market still relies on intermediaries to ply their trade with a high level of skill and insight. If exchange-traded risk brings benefits that don’t rely on the sort of scale it won’t have for at least a decade, then it becomes a useful tool for intermediaries to use with their clients.

5. Standardization: Frictional costs and a reduction in time to execute come from the standardization of instruments in the exchange-traded risk environment. Everyone should have a good sense of what a trade entails—and what sort of protection they’re buying or selling. Consistency and uniformity could help both sides of a trade focus on what’s important—and complete their transactions more accurately in terms of index understanding.

So, what’s missing?

For now at least, liquidity. In the early days of an exchange-traded risk environment, you won’t have the sort of liquidity you’d expect to find in large, well-developed commodities markets. That benefit can be earned only through years of disciplined execution by the market—and the accumulation of other cedent benefits (such as transaction speed and reduced frictional costs). If the environment makes sense trade by trade, liquidity will follow.