The leader of a firm thought to be the world’s largest investment manager of catastrophe bonds told federal lawmakers last week that the insurance-linked securities market is poised to provide billions of dollars to cover terror risk.

Executive Summary

Representatives of the traditional and alternative reinsurance markets say the private market can handle most terror risks, with the exception of NBCR and cyber terror.

John Seo, co-founder and managing principal of Fermat Capital Management LLC, predicted that ILS capacity for terrorism risk will be at least $9-$12 billion by the end of this decade in testimony before the House Financial Services committee on the Terrorism Risk Insurance Program Reauthorization Act last Wednesday.

Even more ILS capacity is possible if nuclear, biological, chemical and radiological coverage is excluded from the ILS terror package, he said, joining another presenter, Kean Driscoll, chief executive officer of Validus Reinsurance, in calling for a government program to address NBCR.

“There is no doubt in my mind that NBCR coverage is holding back market capacity,” Seo said. “If NBCR were more commonly excluded from coverage, capital markets capacity for terrorism risk would increase significantly from current levels.”

In fact, in his written testimony, Seo noted that his $9-$12 billion prediction could easily soar to $20-$30 billion by the end of the decade. Noting that his $9-$12 billion prediction is based on the historical growth patterns of the entire ILS market and the terrorism portion, he said that the higher numbers are possible if the ILS market starts to embrace coverage of terrorism risk more widely than extrapolations for historical figures indicate. “There are the usual caveats that must surround this rosier projection, but it is definitely not out of the realm of future possibility,” he wrote.

Driscoll, who repeated some of the arguments recently advanced by Edward Noonan, chairman and CEO of Validus Holdings, stressed the ability of the traditional insurance and reinsurance markets to analyze, price and cover terror risk in his testimony before the committee. Like Seo, he recommended that the government terror insurance program should continue to cover catastrophic terrorism loss scenarios related to NBCR, adding cyber terrorism to that list as well and offering several additional recommendations for modifying the program.

“The broader industry cannot effectively address these perils as the breadth of potential events is either unknowable or could potentially bankrupt the industry,” Driscoll said.

That’s not the case for terror risk outside of NBCR and cyber terror, he said, referring to the remainder as “conventional terrorism risk.”

“The question is not whether conventional terrorism risk can be priced [by insurers and reinsurers] but rather the precision of the parameters in a pricing model,” Driscoll testified. “We can and do currently price conventional terrorism risk, and estimate that approximately $7-$8 billion of reinsurance coverage is purchased annually on a standalone basis for conventional U.S. terrorism,” he said, repeatedly emphasizing that these figures exclude coverage that is included as part of general property/casualty, workers compensation and other specialty lines coverages.

“The $7-$8 billion is standalone terrorism treaty reinsurance sold in the United States. There’s many, many billions of dollars of terrorism sold in the reinsurance market that’s bundled together with property and casualty…So the market is substantially bigger than that,” he reported.

During his testimony, Seo referred to bundling as a way to expand the ILS market capacity for terror risk.

Catastrophe bond coverage for terror risk is typically bundled with life and health risk, he reported. Additional bundling could increase efficiency of coverage, he said, giving the example of possibly bundling terror, life and earthquake risk in one transaction. “The main intuition here is simple: Risk bundling reduces frictional costs,” Seo said.

Enter ILS

“I know some market observers have questioned whether capital markets are fundamentally cut out for terrorism risk, Seo said, addressing what he said is a common misunderstanding about ILS investors—that they strictly avoid investments covering events that may also cause temporary drops on the stock market. “I say plainly, this is not true. If it were, we would have no earthquake bonds,” he said.

Money Wave“ILS investors care mainly about fair compensation for the risk, and everything else is secondary to that,” he said.

During his remarks, Seo reviewed the calculation of his $9-$12 billion projection by first examining the historical growth in two parts: the cat bond market and the collateralized reinsurance market, which he defined as “the reinsurance equivalent of the cat bond market.”

“Collateralized reinsurance has paralleled the development of the cat bond market virtually dollar for dollar,” he said, reporting that the ILS market currently stands at $45 billion.

Seo said the cat bond side of the ILS market covers only $1.4 billion in terrorism risk today, estimating a $3 billion figure for the entire ILS market from that cat bond portion.

“At current rates, the ILS market is expected to be in the range of $150-$200 billion by 2020,” Seo said. “By mere extrapolation, this would put ILS terrorism capacity at $9-$12 billion by the end of this decade.”

Initially only covering hurricane and earthquake perils, the market has grown to include tornado, hail, wildfire, disease, flood and terrorism, he said.

“Innovation remains a hallmark of ILS markets,” he said, pointing to the development of the first storm surge bond covering the Metropolitan Transportation Authority in New York issued this year in July.

“It is generally accepted that we are at the beginning of a burgeoning market for flood bonds. A few years ago, most market observers would have considered such a thing as nearly impossible,” Seo said.

Providing more detail in his written testimony, he noted that the ILS market for terrorism risk actually began in October 2003, when the Golden Goal Finance Ltd. deal—a $250 million cat bond deal providing terrorism cancellation coverage to FIFA for the 2006 World Cup—was brought to market. Golden Goal represented 7 percent of the outstanding cat bond market at the time, and terrorism risk has remained at 7 percent of the cat bond market, growing from $250 million to $1.4 billion in cat bond coverage over the last decade, Seo reported. This represents a 19 percent compound annual growth rate, he said.

$9B-plus capacity from ILS likely by 2020, Fermat Capital co-founder says.
“Admittedly, these figures do not indicate an overwhelming trend of historical growth, but they certainly do not support the conclusion that ILS markets have exhibited no appetite for terrorism risk to date. Given the proper information, it seems clear that ILS markets to date have kept an open mind on terrorism risk—nothing more and nothing less,” he wrote.

To further clear up the confusion surrounding investors’ views on correlation risk, Seo distinguished between “fast money” hedge fund investors and “slow money” from pension funds in his written remarks.

Noting that pension funds invest through specialty ILS managers like Fermat Capital, he personally estimates their participation at 60 percent of the ILS market, he said, also noting that Swiss Re estimates that hedge funds make up less than 5 percent of the ILS market.

The smaller, fast-money segment is particularly vocal about correlation risk, according to Seo, who notes that only part of that vocal concern is sincere—arising from highly leveraged positions. The other part is simply “a codified way of asking for a higher yield.”

According to Seo, slow money likes ILS, believing that ILS offers returns that have a low correlation to stock and bond returns. In addition, slow money measures correlation over a longer time horizon—”years as opposed to days, weeks or months.”

“Even if there were some possibility that an insured loss event might cause longer-term damage to stock and bond returns, slow money would ask: ‘Is that risk, already borne by stock and bond investors, better compensated in ILS than in stocks and bonds?’ The answer to that question is almost universally: ‘ILS pays better for the risk,'” he wrote.

While stock and bond investors “are almost never compensated for bearing extreme event risk,” ILS investors “are almost always paid for the extreme event risks they cover,” he wrote.

Seo’s written analysis concludes by noting that for slow money, “any lack of correlation with stock and bond returns is icing on the cake, but fair compensation for the risk is of the greatest importance in the end.”

(For more details of Seo’s written testimony, see related article, “Fast Money Hedge Funds Won’t Keep Pension Funds Out of Terror Market, Says ILS Manager.” For an opposing view, see related article, “Terror Risk Bond Market Unlikely, Says Swiss Re Americas CEO. )

Reinsurer’s Recommendations

Providing a viewpoint from the standalone terror reinsurance market, Driscoll outlined recommendations for the Congressional panel about modifications to TRIA. Among them were clarifying the process for certifying a terrorism event—including a defined time for making the certification—and increasing the insurance industry retention.

Terrorism security“We believe presently there is adequate reinsurance capacity to cover the insurance industry’s current $27.5 billion retention under TRIA, and if the industry retention for conventional terrorism exposure grew over time, so too would the capacity of the reinsurance industry for conventional terrorism risk,” Driscoll said.

In addition, Validus recommends increasing the size of a qualifying terrorism loss under TRIA and expanding the co-participation to better align the insurance industry with the program.

Driscoll also recommended that special consideration should be made for smaller insurers, as well as for the insurance industry generally with respect to workers compensation exposure accumulations in metropolitan areas, which could be disproportionately impacted in the near term by any of the changes to the government program, although he didn’t elaborate on what the special considerations might be.

“Congress should encourage a greater private sector risk-bearing role and appropriate risk pricing,” Driscoll emphasized. “Insureds and insurers will then have an incentive to mitigate risk and price it appropriately, and Congress can focus on genuinely becoming a ‘reinsurer’ of last resort for conventional terrorism risk.”

Driscoll expanded on the point with further testimony, saying: “The insurance industry is a critical facilitator of effective risk management in virtually every industry and every facet of life. Risky behavior or highly exposed assets typically result in a higher premium charge. Policyholders can reduce higher premiums through effective risk mitigation techniques.

“Currently, the program impedes the ability of the insurance industry to properly price its products by shifting the risk of a conventional terror attack from the policyholder to the taxpayer. The improper allocation of a risk premium facilitates unintended outcomes.

“We see this phenomenon playing out in the flood market, as the heavily subsidized National Flood Insurance Program has produced significant deficits,” Driscoll said.

During an earnings conference call last month, Validus Holdings CEO Noonan made a similar point. “The government is providing essentially free reinsurance” for terror risk, he said.

Distinguishing between his roles as a U.S. taxpayer and a Bermuda reinsurer, Noonan added: “When I come to work in Bermuda, I get paid for taking terrorism risk. When I go home at night, I’m actually providing terrorism reinsurance to the world for nothing.

“I like coming to work for that reason,” he said.

Addressing Modeling Myths

Noonan (during the conference call) and Driscoll (in his testimony) also addressed the idea that modeling terror risk is impossible for insurers and reinsurers.

“Conventional terrorism can be modeled, priced and managed on a portfolio basis,” Driscoll said.

“The probability or frequency of an event can be estimated, albeit with less certainty than risk classes with a more robust historical record,” he said.

Although another presenter, Sean McGovern, director of risk management and general counsel for Lloyd’s of London, cited modeling issues among the factors that “act to substantially limit the appetite of the insurance and reinsurance industry to absorb terror risk,” Driscoll and Noonan assert that “the insurance and reinsurance industries have pioneered risk transfer solutions for many other classes of business that suffer the same shortcomings.”

Lacking a rich data set on event frequency, “we use open source intelligence that helps us estimate both the intent and capability of terror threat agents,” Driscoll said.

“Since 2001, insurers and reinsurers have worked hard to develop a better understanding of conventional terrorism risk. Reinsurers have created task forces, consulted military and intelligence experts, hired specialty risk modeling firms, invested in research and development, and implemented new underwriting standards all with the intention of offering private market solutions for the transfer of conventional terrorism risk.”

According to Driscoll’s written testimony, Validus Re is one of the largest standalone property-terrorism treaty coverage providers in the world, with an estimated 10 percent market share. The reinsurer evaluates business opportunities on approximately 90 percent of all direct and facultative terrorism business written throughout the world, he said.

In addition, Talbot Syndicate 1183 at Lloyd’s, another member of Validus Group, has written direct and facultative terrorism business at Lloyd’s for more than 12 years and is now the largest writer of that business by income.

More Views on TRIA Modifications

Also testifying before the House committee last week were McGovern from Lloyd’s; Ernst Csiszar, the former director of insurance for South Carolina; and Robert P. Hartwig, president of the Insurance Information Institute—and like Seo and Driscoll, all supported the reauthorization of TRIA. McGovern and Hartwig, however, recommended fewer changes, while Csiszar proposed some radical ones.

For more information on their testimony and highlights of the question-and-answer session of the hearing, see related article, “TRIA Changes Debated.”

Topics Catastrophe USA Excess Surplus Flood Reinsurance Market Lloyd's