The case for non-CAT property insurance-linked securities
With a very favorable market outlook, why has the ILS market not fully embraced non-catastrophe property lines?
The size of the global property insurance market is estimated to be $450 billion by annual premium, but only a small fraction of this exposure makes its way into the insurance-linked securities (ILS) market. Capital markets investors are missing the expected return and potential diversification benefits from a large swathe of the property insurance market. Consistent with how the ILS market evolved risk transfer for catastrophe (CAT) risk, a “win-win” scenario exists for non-CAT property lines as carriers are able to diversify their sources of capital and investors can take advantage of a larger pool of risk that is not correlated with the financial markets.
Non-CAT property is a slight misnomer as these insurance and reinsurance covers are exposed to natural catastrophe losses, albeit at a much smaller scale. Non-CAT covers are primarily designed to absorb losses from non-systemic events such as fire impacting a single risk. These covers will also respond to localized weather events such as severe convective storms and inland floods impacting a limited geography. The systemic risk is placed with the catastrophe market. Reinsurers will typically segment their property line of business between CAT and non-CAT; the latter may be referenced as “property non-CAT” or “other property” and will include quota share and excess of loss products.
As an example, a property insurer will purchase a core CAT treaty which is designed to absorb the systemic risk associated with major disaster events, such as hurricanes, earthquakes and wildfires. This same cedant may purchase a quota share on the same property portfolio as a capital and volatility management tool to respond to all forms of loss including smaller catastrophe events not otherwise meeting the threshold for coverage by the core CAT treaty. CAT risk is mitigated in this non-CAT quota share through the inuring CAT treaty and a per event loss cap.
P&C ILS by all accounts sits at approximately $100 billion of committed capital across a range of products including bonds, sidecars and collateralized deals, primarily focused on natural catastrophe exposures. While the compound annual growth rate (CAGR) of the market over the last 10 years is a healthy 9%, looking at just the last five years implies a stagnating market at a 2% CAGR. Numerous headwinds are responsible for this recent stall, but the main consideration is poor underwriting results in certain higher-risk CAT-exposed product classes leading to investors unwilling to top up losses, and in some cases, redeeming their capital. To reinvigorate market growth using a familiar starting point, we should explore other classes of business that offer a similar investment thesis as property CAT — namely, well-modeled exposures, non-correlated with financial markets and attractive return potential.
Well-modeled exposures
The underlying insured properties feeding into a CAT treaty and a non-CAT treaty for a given cedant are largely the same. This could be a portfolio of residential property, small commercial buildings, complex commercial facilities or some combination thereof. As such, the approach in modeling the CAT risk is the same: The insured’s exposure data is analyzed through CAT models. In a non-CAT treaty, reinsurers integrate actuarial analysis to evaluate the attritional loss exposure. Pricing metrics for a non-CAT treaty are based on the sum of the CAT and non-CAT components.
Non-correlation with financial markets & limited clash with CAT
The ILS market has already conducted extensive research on the diversifying benefits of property CAT in the context of financial markets exposure. Of note, non-CAT property retains all these same benefits but adds further diversification to a pure property
CAT allocation. non-CAT property exhibits low correlation on a modeled basis with other shorter-tail reinsurance portfolios including property CAT; non-CAT property is designed to absorb the idiosyncratic and lower severity CAT risks while CAT XOL is there to absorb the systemic risk. This creates the opportunity to add insurance risk without a material clash with an existing property CAT investment.
Attractive return potential
Robust pricing dynamics seen in the CAT market are also evident in the non-CAT property market as per Exhibit A. Both markets have experienced double-digit risk-adjusted rate change over the last few years leading to a significant compound rate change since 2017. Sharp price increases seen across the property insurance market, including CAT and non-CAT lines, are in direct response to elevated catastrophe losses experienced over the last several years. Pricing dynamics in the non-CAT segment will also be influenced by frequency and severity considerations related to non-headline CAT as well as large risk loss events.
Challenges and outlook
With these benefits including a very favorable market outlook, why has the ILS market not fully embraced non-CAT property? There will be a range of opinions, but consensus would likely center around investor education, structural complexity and past performance.
Capital allocators have become familiar with CAT risk following an extensive education process led by ILS investors and brokers in the years following the devastating impact of Hurricanes Katrina, Rita and Wilma on the industry in 2005. While non-CAT property has very similar attributes to CAT, a similar education process is required for capital allocators to become comfortable with this business line. Fortunately, many of the fundamentals analyzing CAT as an asset class, namely modeling, underwriting and portfolio construction, can be leveraged to truncate the education timeline.
While ILS structuring approaches used for CAT XOL and quota share deals can cross over to non-CAT deals, additional engineering is required to manage the nuances related to the non-CAT product set. For example, coverage terms may extend out to 24 months for a contract whereas CAT deals generally fall into a neat 12-month term. As a result, a longer development timeline may be required to manage the claims cycle. While each individual structural nuance is relatively straightforward, adding these together increases complexity. Cedants and investors will need to carefully evaluate how these features impact return on capital and internal rate of return.
Lastly, broader property insurance lines have had challenging performance over the last few years including CAT and non-CAT. In the non-CAT segment, severe weather events in certain geographies of the United States impacted the market more than expected leading to poor underwriting results. However, insurers and reinsurers have been responding to these challenges by increasing prices significantly, tightening terms and conditions such as raising deductibles and re-underwriting their portfolios to mitigate risk. Market conditions today are very attractive from a historical perspective.
Solving for ILS capacity supporting non-CAT property represents a significant opportunity to grow the market long-term and forge a stronger bond between P&C insurers and the capital markets.
James Lee is a managing director on the Aspen Capital Markets team focused on structuring and placing portfolios of Aspen insurance & reinsurance risk to capital markets investors. His responsibilities include deal structuring and investor relations. Prior to joining Aspen in 2015, he was with Deutsche Bank Securities for 13 years in capital markets roles covering the P&C insurance sector.
Opinions expressed here are the author’s own.
Related: