ILS Intelligence
cakes at spreads that reflected pre-v11 multiples of expected loss. So, if the pricing continues to follow v10-level pricing, and v11 is twice the EL, it must mean that the EL multiple for v11 must be cut in half.
Based on v10 measures of EL, the traditional market ‘rule of thumb’ was that: Spread = (2 x EL) + 5 percent Given that v11 ELs are roughly double what the other modelling firms
are calculating, you would expect that new ELs should be: Spread = (1 x EL) + 5 percent
When we plot v11 EL against spread at origination for recently issued cat bonds, we see almost exactly that (it shows Spread = (0.9 x EL) + 5.1 percent). Having different EL multiples for the different modelling firms suggests
that the market believes the models are good for assessing relative risk (Bond A is riskier than Bond B), but that they are using something else (intuition? conservatism?) for setting the absolute level of required spreads.
v11, we believe the firms that use RMS as their primary model will return to the ILS market—and will expect pricing that incorporates the new view of risk and recognises how it differs from other models.
As this happens we expect that the EL multiples could increase,
reflecting the market’s view that the level of risk has increased; therefore the spread required for a given level of EL (by any of the modelling firms) should be higher.
NEW VIEW OF RISK FITS WITHIN
UNCERTAINTY CUSHION Our calculations suggest that if ELs are accurate, then historical spreads
have had a healthy dose of conservatism—a ‘cushion’—built in, which could also be another reason why the market pricing has not changed following v11. This spread cushion was there to cover model uncertainty— exactly the type of uncertainty demonstrated by the change from v10 to v11, and the v11 view of risk still falls well within this.
Our required return model calculates the required spread for a catastrophe
“As with any significant advance in the science of catastrophe modelling, it can take many months to understand the changes and implement them into decision-making processes.”
WAITING FOR THE ‘TRICKLE-DOWN’ Insurers and reinsurers rely on models to understand both how much
cover (reinsurance, retro or ILS) and the fair price for obtaining that cover. The market is still waiting for the primary insurers and reinsurers to fully implement the v11 view of risk into this process.
Common practice in the re/insurance market is to load cat model results
to account for elements of risk that a company may view as outside the scope of the model. The v10 US hurricane model was commonly loaded, and the initial reaction from many sophisticated model users has been that v11 is more in line with their intuition, reducing the need for such loads.
Importantly, the reinsurance market has dealt with model differences
for many years, with contracts commonly assessed using the results of two or three different models. Firms are therefore able to navigate the uncertainty with model-specific loadings—and under v11, probably significantly smaller RMS loadings than before.
As with any significant advance in the science of catastrophe modelling,
it can take many months to understand the changes and implement them into decision-making processes. With more insurers and reinsurers using
42 | INTELLIGENT INSURER | November 2011
Peter Nakada is managing director of RMS Risk Markets. For more details, please visit
www.rms.com
bond that is being added to a diversified portfolio of uncorrelated risks (eg, equities, corporate bonds). This model assumes that investors need to get paid for contribution to portfolio volatility, and they want to achieve a target Sharpe ratio of 2.0 (a suitably high ratio). The model also assumes that the investors have only 2 percent of their total portfolio invested in any one peril. The chart below shows that for a bond with a 1 percent EL, investors should expect only 3.5 percent above Treasuries, and a bond with 2 percent EL should require a 6 percent spread.
Both of these required spreads are below the typical market spread of 7 percent (2 x 1 percent + 5 percent) that would be charged for a 1 percent EL.
So if the modelled risk is now 2 percent in v11 rather than 1 percent in v10, investors are still getting paid well for the risk they are taking. Taking a leaf out of the re/insurer’s book, we could also view this as a
change in the ‘loading’, giving us a new pricing paradigm of Spread = (1 x RMS EL) + 5 percent.
TIME HEALS We believe RMS v11 is a vastly superior view of risk and one that, while
tough to adjust to in the short term, provides an appropriate benchmark for the management and transfer of hurricane risk.
As the re/insurance market continues its adoption of v11, we expect
this new view of risk to carry on making its way into pricing and portfolio management decisions. In the meantime, even given the new view of risk and the current level of spreads, the ILS market represents good value to diversified fixed income investors.
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